Default, Settlement, and Repayment History: A Unified Model of Sovereign Debt

Abstract

This paper proposes a dynamic model of sovereign debt that combines default, settlement, and repayment history. The model addresses two questions: 1) how level of debt and income proflle afiect the length of time a country in default is excluded from the international credit market, and 2) how repayment history afiects the credit limit and interest rate lenders ofier, and the borrower’s incentive to default. In the model, borrowers weigh the beneflts from defaulting against the penalties associated with it, namely a lengthy exclusion from the market and a potential deterioration in the credit terms. The paper models the settlement as a random process to re∞ect ine‐ciencies that arise due to the existence of private information, but conditions the probability of a settlement on the portion of the defaulted debt borrowers agree to repay. The model incorporates repayment history (i.e., the number of years a country has been active in the international credit market) into the information set used by lenders. Quantitative analysis shows that the model can replicate some key stylized facts of sovereign debt: 1) settlement ofiers depend positively on a debtor’s current income level and negatively on its level of debt; 2) the debt-to-GDP ratio that new borrowers or serial defaulters can support is well below the ratio that proven debtors can safely manage; 3) the probability of default is larger for debtors with recent payment di‐culties; 4) once a country defaults, it takes many years of perfect repayment and low levels of debt for that country to gain continuous access to international credit markets at low cost; this process is slow and backsliding into default is di‐cult to avoid.