Capital Flows, Default, and Renegotiation in a Small Open Economy

44 Pages Posted: 3 Feb 2017 Last revised: 21 Feb 2017

See all articles by Udara Peiris

Udara Peiris

National Research University Higher School of Economics - International College of Economics and Finance

Anna Sokolova

National Research University Higher School of Economics

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall

Date Written: January 31, 2017

Abstract

The post-2008 period focused attention on "twin-crises". Banking crises may lead to sovereign crises where fiscal vulnerabilities are exacerbated by the extension of support for the banking system. We develop a model that describes private sector generated capital inflow that is used to finance investment and consumption expenditure. In the event of an economic contraction, the (convex) haircut on outstanding debt is negotiated, or bargained, centrally by the sovereign. Two results arise: the volume of debt and haircut rate are inefficient. In this setting the accumulation of capital achieves two goals. First, it generates sufficient optimism about future income to allow the debt market to function. Second, and counter-intuitively, it increases expected haircuts by raising the value of the outside option of complete default. These competing forces characterize the optimal balanced-budget macroprudential policy targeting capital investment.

Keywords: open economy, capital flows, debt, default, renegotiation

JEL Classification: F34, G15, G18

Suggested Citation

Peiris, Udara and Sokolova, Anna and Tsomocos, Dimitrios P., Capital Flows, Default, and Renegotiation in a Small Open Economy (January 31, 2017). Saïd Business School WP 2017-03. Available at SSRN: https://ssrn.com/abstract=2910492 or http://dx.doi.org/10.2139/ssrn.2910492

Udara Peiris (Contact Author)

National Research University Higher School of Economics - International College of Economics and Finance ( email )

Pokrovski Bulvar 11, Korpus Zh, Office 715
Moscow, 109028
Russia

Anna Sokolova

National Research University Higher School of Economics ( email )

Myasnitskaya street, 20
Moscow, Moscow 119017
Russia

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 932 (Phone)
+44 1865 288 805 (Fax)

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