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Writing off sovereign debt: Default and recovery rates over the cycle

Laura Sunder-Plassmann

Journal of International Money and Finance, 2018, vol. 81, issue C, 221-241

Abstract: This paper studies the joint determination of sovereign borrowing, default and debt restructuring outcomes. In the data, low debt recovery rates are associated with deep recessions in defaulting countries, high indebtedness at the time of default, and high borrowing costs post-default. I develop a dynamic model of sovereign debt to account for these facts. Recovery rates in the model are determined as the result of two countervailing forces: Cyclical conditions which reduce recovery rates in recessions, and procyclical borrowing which has the opposite effect. The former needs to be sufficiently strong for the model to match the data, and I present empirical evidence and a theoretical rationale for such excess sensitivity of restructuring outcomes to cyclical conditions in the form of countercyclical bargaining power of the sovereign. In the calibrated model, I show that accounting for the cyclicality of recoveries is important for correctly predicting the timing of default events. Procyclical and low recovery rates are detrimental for welfare, but the gains from eliminating the cyclicality are more than twice as high as those from raising average recovery rates.

Keywords: Sovereign default; Debt restructuring; Debt recovery rates (search for similar items in EconPapers)
JEL-codes: F34 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:jimfin:v:81:y:2018:i:c:p:221-241