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Optimal External Debt and Default

39 Pages Posted: 27 Jun 2007  

Bernardo Guimarães

London School of Economics & Political Science (LSE) - Department of Economics

Date Written: January 2007

Abstract

This paper analyses whether sovereign default episodes can be seen as contingencies of optimal international lending contracts. The model considers a small open economy with capital accumulation and without commitment to repay debt. Taking first order approximations of Bellman equations, I derive analytical expressions for the equilibrium level of debt and the optimal debt contract. In this environment, debt relief generated by reasonable fluctuations in productivity is an order of magnitude below that generated by shocks to world interest rates. Debt relief prescribed by the model following the interest rate hikes of 1980-81 accounts for a substantial part of the debt forgiveness obtained by the main Latin American countries through the Brady agreements.

Keywords: Default, optimal contract, sovereign debt, world interest rates

JEL Classification: F3, F4, G1

Suggested Citation

Guimarães, Bernardo, Optimal External Debt and Default (January 2007). CEPR Discussion Paper No. 6035. Available at SSRN: https://ssrn.com/abstract=996884

Bernardo Guimarães (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 (0)20 7955 7502 (Phone)

HOME PAGE: http://personal.lse.ac.uk/guimarae

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