Scribd Logo
Upload

Welcome to Scribd!

  • Financial Crisis 5

    Uploaded by

    Vasu Vijayraghavan
    9 views9 pages

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    9 views9 pages

    Financial Crisis 5

    Uploaded by

    Vasu Vijayraghavan

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 9
    Sovereign Debt: Is to Forgive to Forget? Jeremy Bulow, Kenneth Rogoff The American Economic Review, Volume 79, Issue 1 (Mar., 1989), 43-50. ‘Your use of the ISTOR archive indicates your acceptance of STOR's Terms and Conditions of Use, available at hhup:/www stor orglabout/terms.html. ISTOR’s Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the sereen or printed page of such transmission. ‘The American Economic Review is published by American Economic Association. Please contact the publisher for further permissions regarding the use of this work. Publisher contact information may be obtained at hutp/www,jstor.org/journalsfaca.himl. The American Economic Review (©1989 American Economic Association JSTOR and the ISTOR logo are trademarks of JSTOR, and are Registered in the U.S. Patent and Trademark Office For more information on JSTOR contact jstor-info@umich.edu, ©2001 JSTOR hupslwww jstor.org/ Tue Nov 27 10:18:38 2001 Sovereign Debt: Is to Forgive to Forget? By JeREMY BULOW AND KENNETH RoGorr* We show that, under fairy general conditions, lending to small countries must be supported by the direct sanctions available to creditors, and cannot be supported by a country’s “reputation for repayment.” This distinction is eritically important Jor understanding the true underlying structure of sovereign lending contracts, and comparing policy alternatives for dealing with the developing country debt prob- Tem. The period from 1973 to 1982 saw a startling increase in the volume of interna- tional loans to less-developed countries. A central issue in analyzing LDC loan con- ts is whether, and by what mechanism, these contracts can be enforced. Whereas domestic loans are generally supported by substantial collateral, the assets that can be appropriated in the event of a sovercign’s default are generally negligible. For this rea- son one must look beyond collateral to find incentives for repayment. ‘An influential body of research holds that small country can enjoy at least some access to world capital markets by maintain- ing a reputation for repaying its loans.” Ac- cording to this approach, a country makes Tepayments on its foreign debt in order to preserve reputational “collateral” needed for *Graduate School of Business, Stanford University, Stanford, CA 94305 and Economics Department, Univ versity of Wisconsin, Madison, Wisconsin $3706, This ‘work has been supported by grants from the National Science Foundation under grant no. SES-87-20800 and the Alfed P- Sloan Foundation, "Theories that ignore contract enforcement problems suggest that there should be far greater integration of World capital markets than curently occurs. For a Survey ofthe empirical evidence on international capital mobility, see Maurice Obstet (198) “Examples include Jonathan Eaton, Mark Gersovite, and Joseph Stiglitz (1986): Herschel Grossman and John Van Huyck (1988); Rodolfo Manuel 1986); and Harold Cole and Wiliam English (1987). Eaton and Gersovit (1981) present model in which the threat of capital market autarky provides debtors sith an ince tive to make repayments. However, they do not empha sSze a distinction between a cutoff caused by the legal ‘ghts of oustanding debt, and acute caused bya less ‘of reputation for repayinen 8 future borrowing, The obvious appeal of pure reputation theories is that they seem robust to institutional detail. One does not have to speculate on the legal rights of creditors within their own countries’ courts, or on the ability of creditors to induce their govern- ments to take retaliatory actions. But we have come to query reputation- for-repayment theories, not to praise them. Our analysis establishes rather general con- ditions under which small countries cannot establish a reputation for repayment. If these conditions are met empirically, then loans to LDCs are possible only if creditors have cither political rights which enable them to threaten the debtor's interests outside. its borrowing relationships, or legal rights. Le- gal rights might include the ability to impede a country's trade, or to seize its financial assets abroad (which is the real reason why a defaulter suffers reduced access 10 capital markets). Admittedly, there are many uncer- tainties surrounding the actual damage which a lender can inflict on an LDC; it is a gray area of Western law.’ But if one wants 0 understand LDC loan contracts, then these costs must be studied further. I. The Model Our paradigm is of a small country that faces competitive, risk-neutral foreign in- vestors. (It is straightforward to extend our Fora discussion ofthe legal evidence on this point and an assessment of its probable empirical sgn tance, see Jeremy Bulow and Kenneth Rogo (1989), or TTewis Alexander (1987) “ THE AMERICAN ECONOMIC REVIEW analysis to the case of risk-averse foreign lenders) ‘The country is small in the sense that it cannot affect the world interest rate r It is inhabited by a single, infinitely lived representative agent. There is one good, Which the agent both produces and. con- umes, Since the proof ‘of our theorem is based on an arbitrage argument, itis not necessary to place any restrictions on the agent's tility function other than that she prefers having more of the good to having less. “Te country’s production function i given by a) % (0.7). where Y denotes output, and 1 subscripts denote time. 6, (0 0,-08,-2.-.); the 6's fare exogenous, serially independent distur- bance terms.” J, (lina) where J, is investment in period ¢.'Net ex. ports in period 1, X,, are given by G Q) XY, a C,120;¥>0;C+1 0 always, an assumption which slightly simp fies our proofs.’ Note that W, is defined with reference to a particular (possibly reputa- tional) equilibrium path and that expecta tions, E,, are taken with reference to that equilibritim.® We assume that My 0 canbe dispensed swith in the proof of Theorems 1 and 2 by eeplacing, y wih y* and IY with 1 “along any equilibrium path Fis a function of 8, so Y and W may be writen a funtios of # alone VOL. 79 No.1 it will never again be allowed to write rep- utation contracts. However, the defaulting country cannot be cut off from international capital markets entirely. Though it may no longer be able to borrow for domestic invest- ‘ment, it can still buy consumption-insurance contracts by paying cash in advance. A “cashein-advance” contract is just a conven- tional insurance contract under which a country makes a payment up front in return for a state-contingent, nonnegative future payment. Implicity, we are assuming that there are foreign investors who can make commitments. These commitments are en- forced by the legal system in investors’ coun- tries, Thus a small country can hold foreign assels such as bank accounts, treasury bills, stocks, and other state-contingent assets.” Of course, it can also stockpile reserves of pre- cious metals and foreign currency. A. Reputation Contracts ‘Suppose the country were allowed to have a reputation contract which, in essence, is an implicit contract. For our purposes, itis not necessary 10 ask what set of off-the-equi librium-path beliefs might support the con- tract, nor is it important to ask whether the contract is optimal in any sense. All one needs to know is that any reputation con- tract must implicitly specify a state-contin- gent payment P(6,) for all possible realiza- tions of @, and for all Note that for an implicit contract to be equilibrium, it must be in the country’s in- terest to honor the contract in every possible state of nature. In particular, the country must never have an incentive to default on its reputation contract and switch com- pletely over to cash-in-advance contracts. Notable efforts to study international lending in a general equilibrium framework inciade Manvell (1986) fing Cole and English (1987. "This specification ‘does not prechide randomized strategies One can view 8, a5 a Vector, one of whose tlement has no effect om fundamentals such as output If the foreign investor can make legal commitments, then the implicit contract and the expt legal contract, will coincide whenever P <0. In states of nature where P'> 0, any explicit legal contract is meaningles, by ‘sumption AULOW AND ROGOFF: SOVEREIGN DEBT “6 Otherwise, the contract is not the true im- plicit contract. Given the implicit contract, one can write the world market value of the country's rep- utation debt at time 1, D,, as the expected present-discounted value of its future repay- ments: () plajse[ Eesa+r) ‘| eee Clearly, D, can never exceed W,, the market value of a claim to the country’s entire fu- ture output stream. Thus within any reputa- tional equilibrium there must exist some K’,0- k(W,~ y,). Then the coun- try can cease payment on its reputation con- tract and initiate the following sequence of cash-in-advance contracts: For all 125, invest 4, in return for a payment of G,,, in the ensuing period where: (8) A,(d) = PB) + OW, — (9) A 8) =6(8)+ P(G)— by, Vers, (19) G(@) =4W(F)—_D[G), ve>s. Since D,s, with equality holding ‘only when k=0. Thus k must equal zero and by (5), D, <0 Ve ‘That is, any (implicit) reputation contract ‘must include at least some state of nature in which the country will default. The country will be able to use whatever repayment is demanded in that state of nature, an amount which may be very small relative to out- standing debt, as initial collateral for a series of cashr-in-advance contracts. These con- tracts will allow the country to have strictly higher consumption in cach future period than it would get under the reputation con- tract. This implies that the proposed implicit contract eannot be the true implicit contract. A reputation contract can only be equilib- rium if we assume that the country cannot hold foreign assets that are indexed to the same variables as the reputation contract. B. Reputation Contracts When Lenders Have Direct Means for Punishing Default In the preceding analysis, we assumed that holders of reputation contracts have no way to directly punish the country if it repudi- ates. Here we show that if there are some direct costs which lenders can impose on ‘country in the event of default, then loans can be sustained, but only on the basis of these costs. Suppose that lenders have the ability to impose a random penalty of ,(@,,7,) if a borrower stands in default in period 1, where 11 is independent of @ and y,>#,>0. The penalty causes the country’s period-1 output to be reduced by 1, Define Sastry (3), Since D, can never exceed W,, then there ‘must exist some q’.0

    You might also like