Sovereign default and debt renegotiation

Abstract

In this paper, we develop a small open economy model to study sovereign default and debt renegotiation within a dynamic borrowing framework. The model features both endogenous default risk and endogenous debt recovery rates. A country’s future borrowing and default decisions affect the determination of debt recovery rates in a Nash bargaining game; whereas the endogenous debt recovery rates, in turn, influence the country’s ex ante incentive to default. Sovereign bonds are priced to compensate creditors for the risks of default and debt restructuring in equilibrium. We find that both equilibrium debt recovery rates and sovereign bond prices decrease with the level of debt. In a quantitative analysis, the model successfully accounts for the volatile and countercyclical bond spreads, countercyclical current account and other empirical regularities of the Argentine economy. The model also replicates the dynamics of bond spreads during the recent debt crisis in Argentina. Furthermore, we show that introducing an endogenous debt recovery schedule leads to a higher default probability and greater interest rate volatility.