TY  - JOUR
AU  - Grossman,Herschel I.
AU  - Huyck,John B. Van
TI  - Sovereign Debt as a Contingent Claim:  Excusable Default, Repudiation,  and Reputation
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 1673
PY  - 1989
Y2  - August 1989
UR  - http://www.nber.org/papers/w1673
L1  - http://www.nber.org/papers/w1673.pdf
N1  - Author contact info:
Herschel Grossman
Department of Economics
Box B
Brown University
Providence, RI  02912
Tel: 401/863-2606
Fax: 401/863-1970

John B.. Van Huyck
Department of Economics
Texas A&M University
College Station, TX  77843
E-Mail: john.vanhuyck@tamu.edu
AB  - 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.
ER  -