Seminar

Optimal external debt and default

Bernado Guimaraes (London School of Economics)

May 25, 2009, 17:00–18:30

Toulouse

Room MF 323

Political Economy Seminar

Abstract

This paper analyses a small open economy that wants to borrow from abroad, cannot commit to repay debt but faces costs if it decides to default. I study the optimal debt contract in this world in order to quantify the impact of shocks on the incentive compatible level of debt. Debt relief generated by severe output shocks is no more than a couple of percentage points. In contrast, shocks to world interest rates can generate debt relief one order of magnitude higher. Debt reduction prescribed by the model following the interest rate hikes of 1980-81 accounts for over half of the debt forgiveness obtained by the main Latin American countries through the Brady agreements.

Keywords

sovereign debt; default; optimal contract; world interest rates;

JEL codes

  • F34: International Lending and Debt Problems