Tag Archives: External debt

Why Do Sovereigns Repay External Debt?

In a Vox blog post (that complements another post on Greece), Jeremy Bulow and Ken Rogoff review the academic discussion on a long-standing question—why sovereigns repay their external debt.

Bulow and Rogoff distinguish between

[t]he ‘reputation approach’ pioneered by Eaton and Gersovitz (1981) which builds on Hellwig (1977);
and the ‘direct punishments’ bargaining-theoretic approach of Bulow and Rogoff (1988b, 1989a) which in turn builds on Cohen and Sachs (1986).

They argue that the latter approach—attributing enforceable rights in foreign country courts to creditors—better explains observed outcomes.

[The] direct punishment/bargaining approach lends itself very naturally to incorporating moral hazard; …
reputation models suggest [counter factually] that the governing law of the debt is irrelevant;
[i]n standard reputation for repayment models, write-downs are decided unilaterally—creditors’ particular concerns do not really matter; …
[t]he interests and welfare of unrelated third parties does not matter in standard reputation models; …
[r]eputational debtors borrow in bad times and re-pay in good times, for purposes of income smoothing; [d]efaults, if they are to take place, occur in good times … In reality, many countries borrow as much as they can whenever they can. … Debt crises occur when countries do badly and creditors decide they want to reduce their loan exposure. To some extent, this issue can be addressed by assuming that income shocks are permanent and not transitory, but it remains difficult to rationalise country borrowing only on the threat of lost consumption smoothing. …
[c]reditor identity doesn’t matter; …
[u]nder … general assumptions, the existence of [the option to put savings abroad] leads to the unravelling of any purely reputational equilibrium.

Bulow and Rogoff add that

[a]nother important issue … is that in practice, sovereign debt renegotiations focus very much on the flow of repayments, and much less on how the stock of debt evolves. This is precisely because all sides realise that any future promises can be renegotiated.

“Austerity,” CEPR, 2014

CEPR Discussion Paper 10315, December 2014, with Harris Dellas. PDF. Also published as CESifo Working Paper 5146, Study Center Gerzensee Working Paper 14-07. PDF, PDF.

We shed light on the function, properties and optimal size of austerity using the standard sovereign debt model augmented to include incomplete information about credit risk. Austerity is defined as the shortfall of consumption from the level desired by a country and supported by its repayment capacity. We find that austerity serves as a tool for securing a more favorable loan package; that it is associated with over‐investment even when investment does not create collateral; and that low risk borrowers may favour more to less severe austerity. These findings imply that the amount of fresh funds obtained by a sovereign is not a reliable measure of austerity suffered; and that austerity may actually be associated with higher growth. Our analysis accommodates costly signalling for gaining credibility and also assigns a novel role to spending multipliers in the determination of optimal austerity.