Incentive-Compatible Sovereign Debt

This paper presents a theory of sovereign borrowing and lending when there is no court to enforce repayment obligations. Specifically, I extend the costly state verification approach in financial contracting to include an ex-post repayment decision in which the borrower repays creditors to avoid repudiation costs. I derive the optimal loan contract, which I call “repudiation-proof debt,” and show how it saves on costly verification and avoids repudiation. Repudiation-proof debt can explain several key facts of sovereign borrowing: (i) why governments issue bonds in the first place; (ii) why strategic defaults occur even under the optimal loan contract; (iii) why such defaults are neither marginal nor total repudiation; and (iv) how repudiation costs mitigate sovereign risk and determine debt capacity in the absence of enforcement.