A Dynamic Model of Sovereign Debt and Defaults: Understanding the Incentives of the Borrower

Abstract

This paper develops a non-stochastic sovereign-debt dynamic model, with increasing cost of capital. It finds that there are parameters for which there is a stable fixed borrowing level, and there are parameters for which the model depicts the case of serial defaulters. Levels of debt that tend towards the fixed point eventually achieve higher levels of consumption than would be attainable under financial autarky. In the cases of unstable paths (those that eventually end in default), consumption decreases as debt increases, because an increasing amount of domestic production needs to be added to current borrowing in order to pay debt obligations. The model shows how, as the cost of capital decreases, the equilibrium level of borrowing increases, and more levels of debt become sustainable in the long run. On the other hand, higher desired returns from creditors have the effect of lowering the stable borrowing level and the threshold for sustainable levels of debt. Very high levels of desired returns, R, may lead countries to become serial defaulters. This occurs because the stable equilibrium point disappears and every initial borrowing amount ends in default. A high level of R is not the only thing that can take a country to a state of chronic default; short punishments for defaulting are far more important. In the benchmark model, at least 21 periods of punishment are necessary to avoid chronic defaults. High levels of impatience can also make a country a serial defaulter.