I develop a model in which sovereign debtors repay debt in order to
maintain a reputation for repayment. Repayment gives creditors reason to
think that the debtor will suffer adverse consequences if it defaults, so
they continue to lend. I compare a situation in which competitive lenders
earn a zero profit on each loan with one in which they can make long-term
commitments to individual borrowers, so that the zero-profit condition
applies only in the long run. In many circumstances a borrower benefits, ex
ante, if lenders commit to denying credit to a borrower in default even if at
that point a subsequent loan is profitable. Furthermore, a "debt overhang,"
while possibly altering credit terms, does not cause profitable investment
opportunities to go unexploited.
*Published:
International Jouranl of Finance and Economics, Vol. 1, No. 1, pp.25-36 January 1996
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