Incentive-Compatible Sovereign Debt

39 Pages Posted: 28 Aug 2012 Last revised: 13 Nov 2013

Date Written: October 15, 2013

Abstract

This paper presents a theory of sovereign borrowing and lending when there is no court to enforce repayment obligations. Specifically, I extend the costly state verification approach in financial contracting to include an ex-post repayment decision in which the borrower repays creditors to avoid repudiation costs. I derive the optimal loan contract, which I call “repudiation-proof debt,” and show how it saves on costly verification and avoids repudiation. Repudiation-proof debt can explain several key facts of sovereign borrowing: (i) why governments issue bonds in the first place; (ii) why strategic defaults occur even under the optimal loan contract; (iii) why such defaults are neither marginal nor total repudiation; and (iv) how repudiation costs mitigate sovereign risk and determine debt capacity in the absence of enforcement.

Keywords: sovereign debt, costly state verification, financial contracting, repudiation risk, strategic default

JEL Classification: D02, D82, F34, G15, H63

Suggested Citation

Bersem, Mario R.C., Incentive-Compatible Sovereign Debt (October 15, 2013). Available at SSRN: https://ssrn.com/abstract=2136504 or http://dx.doi.org/10.2139/ssrn.2136504

Mario R.C. Bersem (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

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