IN SOVEREIGN DEBT contracts, borrowers are unable to offer collateral in the traditional sense. Instead, lenders must rely on the sovereign country’s desire to maintain unfettered access to world capital and goods markets. But although the costs of being forced into economic autarky are almost certainly enormous for most debtor countries, the bargaining over debt repayments is not entirely one-sided. Debtor countries have some leverage because foreign lenders do not directly benefit by cutting them off from world markets. Moreover, in punishing a debtor who repudiates, lenders may also be inflicting damage on their own compatriots. In particular, they will be hurting any creditor-country citizens who benefit from trade with the debtor. A conflict of interest can arise among different groups in the creditor countries, pitting investors who want to enforce maximum repayments against consumers and exporters who want to maintain normal trade relations.
This paper attempts to develop a formal bargaining-theoretic model that takes into account the multilateral dimensions of developing country debt reschedulings. Previous efforts to model sovereign debt contracts have typically focused only on the bilateral relationship between the debtor nation and its foreign private creditors, taking the behavior of creditor-country governments as exogenous.1 Because it would be rather difficult to develop a complete general equilibrium, game-theoretic model of international economic relations, we do need to treat some aspects of creditor-country policy as exogenous. In particular, we take the creditor nations’ political and legal systems as given. Nevertheless, our analysis yields some insights that we believe would hold up in a richer model.
Our central result is that if creditor-country citizens enjoy sufficiently large gains from trade with the debtor country, they may be induced to facilitate rescheduling agreements by contributing money or by consenting to policy changes that would be favorable to the debtor country or the banks (that is, by making “sidepayments”). They may be induced to make sidepayments even though all parties have a common interest in avoiding trade disruptions. But there is an important distinction between anticipated and unanticipated sidepayments. Unanticipated sidepayments benefit both debtors and bank stockholders. If, however, lenders anticipate receiving third-party sidepayments, they will be willing to lend more at any given interest rate. With competitive loan markets, the borrowing country is thereby able to extract the entire surplus.
Alexander, Lewis S., “The Legal Consequences of Sovereign Default,” (unpublished; Washington: Board of Governors of the Federal Reserve System, 1987).
Bulow, Jeremy, and Kenneth Rogoff (1989a), “A Constant Recontracting Model of Sovereign Debt,” Journal of Political Economy (Chicago), Vol. 97 (February, forthcoming).
Bulow, Jeremy, and Kenneth Rogoff (1989b), “Sovereign Debt: Is to Forgive to Forget?” American Economic Review (Nashville, Tennessee), Vol. 79 (March, forthcoming).
Eaton, Jonathan, Mark Gersovitz, and Joseph E. Stiglitz, “The Pure Theory of Country Risk,” European Economic Review (Amsterdam). Vol. 30 (June 1986), pp. 481–513.
Johnson, Harry G., “Optimum Tariffs and Retaliation,” Review of Economic Studies (Edinburgh), Vol. 21 (1954), pp. 142–53.
Rubinstein, Ariel, “Perfect Equilibrium in a Bargaining Model,” Econometrica (Evanston, Illinois), Vol. 50 (January 1982), pp. 97–109.
Sutton, John, “Non-Cooperative Bargaining Theory: An Introduction.” Review of Economic Studies (Edinburgh), Vol. 53 (October 1986), pp. 709–24.
Mr. Bulow is a Professor in the Graduate School of Business at Stanford University. Mr. Rogoff is a Professor of Economics at the University of Wisconsin, Madison, This paper was prepared while he was a visiting scholar in the Research Department of the Fund.
For an analysis of the case where bargaining is bilateral, see Bulow and Rogoff (1989a). See Eaton, Gersovitz, and Stiglhz (1986) for a discussion of the early literature, in which creditors are implicitly assumed to have all the bargaining power.
Even if no special problems enforcing contracts across national borders existed, one still could not index legal contracts to variables that are only observed by one of the two contracting parties, or to variables that both parties observe but that are prohibitively expensive for a third party (for example, a court) to verify.
An alternative view holds that sovereign debtors repay mainly to preserve their reputation for repayment in world capital markets. For a skeptical assessment of this view, see Bulow and Rogoff (1989b).
We are somewhat overstating the differences between domestic and international contracts here. Indeed, many of the bargaining issues analyzed here are present in the domestic setting, albeit in less acute form.
The discussion of bilateral bargaining here is based on our earlier paper (Bulow and Rogoff (1989a)).
Allowing the time interval to be of arbitrary length h will make it easier later to consider the limiting case of continuous bargaining.
The model here may be thought of as holding constant the aggregate bargaining power of the banks relative to the country. In the bargaining analysis below, this is tantamount to saying that the banks’ share of the offers is fixed.
The banking consortium typically includes representatives from all the borrower’s major industrial country trading partners; this situation maximizes lenders’ legal rights in the event of default.
As Bulow and Rogoff (1989a) show, it is not difficult to allow for uncertainty in this framework. The focus here is on the extension to multilateral bargaining; our main results do not depend on the assumption of perfect foresight.
In practical terms, it is best to think of this payment as the net resource transfer from the country to its creditors. The net resource transfer is essentially the country’s current interest payment minus any so-called new money loans.
Although we do not stress it here, there is actually a fundamental difference between our model and Rubinstein’s. In Rubinstein’s model, once an agreement is reached, it cannot be renegotiated. Here, the country always has the option of asking for rescheduling of the agreement. To solve this problem in general is quite difficult, but it is possible to solve the model for the risk-neutral case considered here.
Note that we are assuming that the profits of bank investors do not enter into the creditor-country government’s utility function. Similar results obtain as long as the creditor-country government values an extra dollar of bank profits less than an extra dollar of government surplus.
Note that the creditor-country’s sidepayments can take many forms other than cash payments: military assistance, a lowering of tariffs, changes in immigration laws, and so forth.
The analysis would be similar if the creditor country also could store some of its own export good. The key assumption here is that both sides’ gains from trade are linear in the level of bilateral trade; the model is much easier to solve in the linear case.
The derivation of equations (8) follows the same algorithm presented in Bulow and Rogoff (1989a) for the bilateral case. In deriving the conditions for an equilibrium bargain, we have not allowed for history-dependent strategies. One can show, however, that the equilibrium considered in the text is the unique equilibrium of the limiting finite-horizon game, and it is also the unique equilibrium when strategies are continuous in the history of the game; see Sutton (1986).