Optimal External Debt and Default
Paper No' CEPDP0847:
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Keywords: sovereign debt; default; capital flows; optimal contract; world interest rates
JEL Classification: F3; F4; G1
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This Paper is published under the following series:
CEP Discussion Papers
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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.