Review of Economic Dynamics 14 (2011) 553–576
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Review of Economic Dynamics
www.elsevier.com/locate/red
Sovereign default: Which shocks matter?
Bernardo Guimaraes
a
,
b
,∗,
1
a
Sao Paulo School of Economics/FGV, Brazil
b
London School of Economics, United Kingdom
article info abstract
Article history:
Received 24 July 2009
Revised 8 October 2010
Available online 15 October 2010
JEL classification:
F34
Keywords:
Sovereign debt
Default
World interest rates
Output shocks
This paper analyses a small open economy that wants to borrow from abroad, cannot
commit to repay debt but faces costs if it decides to default. The model generates analytical
expressions for the impact of shocks on the incentive compatible level of debt. Debt
reduction generated by severe output shocks is no more than a couple of percentage points.
In contrast, shocks to world interest rates can substantially affect the incentive compatible
level of debt.
©
2010 Elsevier Inc. All rights reserved.
1. Introduction
What generates sovereign default? Which shocks are behind the episodes of debt crises we observe? The answer to
the question is crucial to policy design. If we want to write contingent contracts,
2
build and operate a sovereign debt
restructuring mechanism,
3
or an international lender of last resort,
4
we need to know which economic variables are subject
to shocks that significantly increase incentives for default or could take a country to “bankruptcy”.
I investigate this question by studying a small open economy that wants to borrow from abroad, cannot commit to repay
debt but faces costs if it decides to default. There is an incentive compatible level of sovereign debt — beyond which greater
debt triggers default — and it fluctuates with economic conditions. The renegotiation process is costless and restores debt
to its incentive compatible level. The model yields analytical expressions that allows us to quantify the impact of different
shocks on the incentive compatible level of debt.
One important result from this framework is that shocks to domestic productivity (or output) do not generate sizable
fluctuations in the incentive compatible level of debt. Following a severe output shock, debt relief of a couple of percentage
points would restore incentive compatibility. This is consistent with some empirical evidence (Tomz and Wright, 2007),
*
Address for correspondence: Sao Paulo School of Economics/FGV, Brazil.
E-mail address: bernardo.guimaraes@fgv.br.
1
I thank Giancarlo Corsetti, Nicola Gennaioli, Alberto Martin, Silvana Tenreyro, Alwyn Young, the anonymous referees and, especially, Francesco Caselli
and the associate editor for helpful comments, several seminar participants for their inputs, and Zsofia Barany and Nathan Foley-Fisher for excellent research
assistance financed by STICERD.
2
Borensztein and Mauro (2004) argue for GDP-indexed debt. Kletzer et al. (1992) defend indexing debt payments to commodities prices.
3
Krueger (2002) and Bolton and Jeanne (2007) argue for a sovereign debt restructuring mechanism.
4
Fischer (1999) argues for an international lender of last resort.
1094-2025/$ – see front matter
©
2010 Elsevier Inc. All rights reserved.
doi:10.1016/j.red.2010.10.002