The global financial market is currently undergoing one of the worst and perhaps most damaging financial crisis since the Great Depression. This crisis is affecting countries from all over the globe and it appears that no country is immune from the current financial malaise. Unfortunately, the global financial are not new. Indeed, over the past three decades, the global financial market has witnessed several financial crises involving mainly developing countries from Latin America to East Asia. These past events; however, were not as widespread and severe as the one presently being faced.
When faced with a financial crisis, however, debtor countries rarely opt to default on their international financial obligations. Instead, they typically choose to renegotiate their debt obligations (Kletzer and Wright (2000)). This begs the question of why countries choose to renegotiate instead of defaulting on their debt obligations? In the same vein, why do creditors agree to renegotiate instead of allowing debtor countries to default on their debt obligations? That is, what is the motivation behind borrowers’ and creditors’ willingness to renegotiate and restructure existing debt obligations?
According to a number of economists, the answer to the first part of this question may be that debtors wish to preserve their international trade ties. Otherwise, Bulow and Rogoff (1989a) state that defaulting countries may suffer reduced benefits of international trade. Since international trade accounts for a large percentage of debtor countries’ GDP, borrowing countries may choose to renegotiate in order to avoid de facto trade sanctions (For example, Chile’s trade (imports and exports combined) as a percentage of GDP was 80.38% and 84.78% for the Philippines in 2007). Debtor countries may also choose to renegotiate to preserve their creditworthiness and to secure future access to international capital markets.
What about the creditors? What are their incentives? According to Klimenko (2002) and Rose and Spiegel (2004), outright default is inefficient since the debtor’s welfare loss caused by trade sanctions does not accrue as a benefit to the creditors. Instead, creditors prefer a negotiated outcome that allows the debtor country to freely trade in exchange for a share of welfare gains made possible by avoiding default. In addition, if creditor countries have significant economic ties with the borrowing country, it may be in their interest to work with the borrower.
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Bargaining game and LDCs’ commercial bank debt restructuring outcomes
