Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation / Herschel I. Grossman, John B. Van Huyck.

Format:

Book

Author/Creator:

Grossman, Herschel I.

Contributor:

National Bureau of Economic Research.

Van Huyck, John B.

Series:

Working Paper Series (National Bureau of Economic Research) no. w1673.

NBER working paper series no. w1673

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Other Title:

Sovereign Debt as a Contingent Claim

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 1985.

Summary:

History suggests the following stylized facts about default on sovereign debt:(1) Defaults are associated with identifiably bad states of the world. (2) Defaults are usually partial, rather than complete.(3) Sovereign states usually are able to borrow again soon after a default. Motivated by these facts, this paper analyses a reputational equilibrium in a model that interprets sovereign debts as contingent claims that both finance investments and facilitate risk shifting. Loans are a useful device to facilitate risk shifting because they permit the prepayment of indemnities. Nevertheless, because the power to abrogate commitments without having to answer to a higher enforcement authority is an essential aspect of sovereignty, a decision by a sovereign to validate lender expectations about debt servicing depends on the sovereign's concern for its trust worthy reputation. A trustworthy reputationis valuable because it provides continued access to loans. A key aspect of the analysis is that lenders differentiate excusable default, which is associated with implicitly understood contingencies, from unjustifiable repudiation. In the reputational equilibrium, the short-run benefits from repudiation are smaller than the long-run costs from loss of a trustworthy reputation. Thus, although sovereigns sometimes excusably default, they never repudiate their debts. The reputational equilibrium can involve efficient risk shifting and efficient investment or it can involve a binding lending ceiling that limits risk shifting and can also restrict investment. The factors that tend to produce a binding lending ceiling include a high time discount rate for the sovereign, low-risk aversion forthe sovereign, and a low net return from the sovereign's investments.

Notes:

Print version record

July 1985.