Debt Renegotiation and Sovereign Defaults
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Debt Renegotiation and Sovereign Defaults


This study develops a model of endogenous default with debt renegotiation for emerging economies. A small open economy faces a stochastic stream of income. The government borrows from international financial markets and makes decisions on behalf of the country’s residents. Lenders are risk-neutral and operate in a perfectly competitive financial market. Upon default, the borrowing country and the lenders engage in debt restructuring negotiations which are modeled by a Nash bargaining game. The models are calibrated to capture the default episodes in Argentina. This body of work illustrates how adding the endogenous debt negotiation feature to the borrowing-default models can provide results that are closer to the data.The first chapter studies the maturity structure. The government can issue short- and long-term bonds. Upon default, the borrowing country loses access to the financial markets and will not be able to borrow any longer. The defaulted country has to pay off the principal and interest of the restructured debt to regain access to the credit market. The resulting equilibrium haircut is directly related to the debt level. The resulting interest rate distributions for short- and long-term bonds closely match the observed data. Providing a precise interest rate distribution is crucial as finding the optimal maturity structure relies on it. The paper finds that endogenous debt renegotiation is an important mechanism in generating more realistic fluctuations of the interest rate. The second chapter explains how the introduction of Brady Bonds was followed by a reduction in the default frequency in Latin American countries during the 1990s. Prior to that, loans from syndicated banks were used as the main debt instrument. This is puzzling since bondholders have lower bargaining power than syndicated banks, hence borrowing countries are expected to default more frequently. This chapter shows that introducing bonds lower interest rates and, consequently, increases the opportunity cost of default. In the last chapter, we study partial default, that is a borrowing country defaulting on some of the outstanding debt while honoring the rest. The model with endogenous debt negotiations provides results that match the frequency and length of default episodes in data.

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