Sovereign Debt Renegotiation Under Asymmetric Information

Peter Wickham, Jacob Frenkel, and Michael Dooley
Published Date:
March 1989
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    This paper analyzes equilibrium debt contracts under potential renegotiation in the presence of sovereign risk. A simple model of borrowing from abroad to smooth consumption with stochastic national income is studied. Borrowers can choose to repudiate their debt obligations but face sanctions for doing so. With free entry in loan contracts, equilibrium debt renegotiations take the form of reductions in current debt service obligations with a new equilibrium market debt-contract. Under symmetric information, net inflows of funds are never provided in a renegotiation to a recalcitrant debtor. This contradicts part of the rationale given in the literature for a strategy of “defensive lending” to problem debtors. Asymmetric information about some debtor characteristics is introduced, and renegotiation of existing debt service obligations is shown to give rise to separating equilibria. Because of the presence of private information, new net inflows may occur along with significant increases in future debt obligations in the event of renegotiation. The implications of these results for the dynamics of debt-service obligations and several extensions of the simple model are discussed.

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