Incentive-Compatible Sovereign Debt

Mario R. C. Bersem

Research output: Working paperResearch

Abstract

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.
Original languageEnglish
Place of Publicationwww
PublisherSSRN: Social Science Research Network
Number of pages22
Publication statusPublished - 2012

Keywords

  • Soveriegn Debt
  • Costly State Verification
  • Financial Contracting
  • Repudiation Risk
  • Stategic Deafult

Cite this

Bersem, M. R. C. (2012). Incentive-Compatible Sovereign Debt. SSRN: Social Science Research Network. http://ssrn.com/abstract=2136504