Optimal Sovereign Debt Default

Michael Grill and Klaus Adam
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Michael Grill: Deutsche Bundesbank

No 882, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: We determine optimal government default policies for a small open economy in which a domestic government can borrow internationally by issuing non-contingent debt contracts. Unlike earlier work, we consider optimal default policies under full government commitment and treat repayment of international debt as a decision variable. Default can be optimal under commitment because it allows for increased international diversiÃÂcation of domestic output and consumption risk when government bond markets are incomplete. In the absence of default costs, default optimally occurs very frequently and independently of the country's net foreign asset position. Optimal default policies, however, change drastically when a government default entails small but positive dead weight costs: default is then optimal only in response to disaster-like shocks to domestic output, or when a small adverse shock pushes international debt levels sufficiently close to the country's borrowing limit. Optimal default policies increase welfare signiÃÂcantly compared to a situation where default is ruled out by assumption, even for sizable default costs. For sufficiently low level of default costs the optimal default policies can approximately be replicated by issuing a simple equity-like government bond.

Date: 2012
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