Sovereign Default and Debt Renegotiation

Abstract: In this paper, we develop a small open economy model to study debt renegotiation and sovereign default within a dynamic borrowing framework. The model features both endogenous default risk and endogenous debt recovery rates. Sovereign bonds are priced to compensate creditors for the risks of default and debt restructuring in equilibrium. We find that both equilibrium debt recovery rates and sovereign bond prices decrease with the level of debt. In a quantitative analysis, the model successfully accounts for the debt reduction, volatile and countercyclical bond spreads, countercyclical trade balance, and other empirical regularities of the Argentine economy. The model also replicates the dynamics of bond spreads during the recent debt crisis in Argentina.