Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation

Herschel I. Grossman, John B. Van Huyck

NBER Working Paper No. 1673 (Also Reprint No. r1244)
Issued in July 1985
NBER Program(s):Monetary Economics, Economic Fluctuations and Growth

History suggests the following stylized facts about default on sovereign debt:(1) Defaults are associated with identifiably bad states of the world. (2) Defaults are usually partial, rather than complete.(3) Sovereign states usually are able to borrow again soon after a default. Motivated by these facts, this paper analyses a reputational equilibrium in a model that interprets sovereign debts as contingent claims that both finance investments and facilitate risk shifting. Loans are a useful device to facilitate risk shifting because they permit the prepayment of indemnities. Nevertheless, because the power to abrogate commitments without having to answer to a higher enforcement authority is an essential aspect of sovereignty, a decision by a sovereign to validate lender expectations about debt servicing depends on the sovereign's concern for its trust worthy reputation. A trustworthy reputationis valuable because it provides continued access to loans. A key aspect of the analysis is that lenders differentiate excusable default, which is associated with implicitly understood contingencies, from unjustifiable repudiation. In the reputational equilibrium, the short-run benefits from repudiation are smaller than the long-run costs from loss of a trustworthy reputation. Thus, although sovereigns sometimes excusably default, they never repudiate their debts. The reputational equilibrium can involve efficient risk shifting and efficient investment or it can involve a binding lending ceiling that limits risk shifting and can also restrict investment. The factors that tend to produce a binding lending ceiling include a high time discount rate for the sovereign, low-risk aversion forthe sovereign, and a low net return from the sovereign's investments.

download in pdf format
   (174 K)

download in djvu format
   (134 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w1673

Published: The American Economic Review, Vol. 78, No. 5, pp. 1088-1097, (December 1988). citation courtesy of

Users who downloaded this paper also downloaded* these:
Bulow and Rogoff w2623 Sovereign Debt: Is To Forgive To Forget?
Lindert and Morton How Sovereign Debt Has Worked
Eaton and Fernández w5131 Sovereign Debt
Bulow and Rogoff w2088 A Constant Recontracting Model of Sovereign Debt
Reinhart, Rogoff, and Savastano w9908 Debt Intolerance
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us