A Valuation Model for Developing-Country Debt with Endogenous Rescheduling

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Creditors have little recourse if a sovereign state repudiates debt obligations. They can, however, threaten to impose penalties if such action occurs which results in deadweight losses to the system as a whole. A preferred alternative for both borrower and lender is to reconstruct debt obligations. Reschedulings are a device that creditors can use to restructure the incentives faced by borrowers such that repudiation is never a rational action. This article develops a numerical method of valuing the option to reschedule. The model shows why fees are preferred to higher interest spreads during a rescheduling exerise; why maturities get shorter prior to a debt crisis but are lengthened in a rescheduling; and why little has been done to attempt to seize the assets of countries that have not repaid any interest or principal for extended periods of time. The model shows that lenders are willing to commit greater amounts if reschedulings are possible than if they are not, and that precommitment to provide additional funds at rescheduling can raise the market value of existing debt and should not be construed as concessions by commercial lenders. Alternately, the model can be used to improve systems for ranking country creditworthiness, to assess the degree of adjustment requried to spark resumption of spontaneous lending, or to estimate how much interest rates would have to fall to restore a country's creditworthiness.