Sovereign Default, Private Sector Creditors and the IFIs by Emine Boz

Author:Emine Boz
Language: eng
Format: epub
Publisher: International Monetary Fund
Published: 2009-08-15T00:00:00+00:00

In non-default periods, the sovereign decides whether or not to default, and how to allocate its financing needs among the private sector creditors and the IFI. The value of non-default in this setup can be written as:

subject to the budget constraint:

As mentioned above, the risk neutral and perfectly competitive private sector creditors lend at a rate that is mainly determined by the default probability of the sovereign. The commercial bond price schedule is given by:

and the spread is defined as s = 1/q − 1 − r.

In order to capture the conditionality of IMF loans, and also to account for the regularity that sovereigns do not borrow from the IMF every period as documented in Table 5, we assume that the sovereign has to switch to a higher discount factor, that is, a lower discount rate as long as it is indebted to the IFI. Models of sovereign default have traditionally calibrated discount rates such that they are significantly greater than the risk free interest rate. In this fashion, more realistic debt ratios and default probabilities were achieved because, with a low discount factor, the sovereign has a strong desire to consume today and is willing to hold larger amounts of debt in the long run. By assuming that borrowing from the IFI is associated with a higher discount factor, we are building “more prudent” policies that come with conditionality. This can also be interpreted as a reduction in consumption (public consumption in particular) that typically is part of conditionality. More formally:

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