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