Ebook Valuation of Sovereign Debt with Strategic Defaulting and Rescheduling
While the literature of corporate credit risk is advancing at a rapid pace, the issue of sovereign credit risk is still in its early stages. Sovereign debt is different from corporate debt: If a sovereign does not repay the amount which is specified in the debt contract it is not possible to initiate proceedings in a bankruptcy court which allow the lenders to seize all assets of the borrower. This implies that there are greater incentives for a sovereign to strategically default, i.e., to pay less than the contractual amount even if there are enough resources to fulfill the debt contract.
To take account of these factors we will focus on the country’s willingness or incentives to fully honor its obligations rather than on its ability to do so. The model differs from classical corporate credit risk models: It is not the dropping of the company’s asset value under the outstanding face value which triggers default, but rather a decision of the country whether to continue in respecting its commitments or whether to default.
The benefits of defaulting are that the outstanding debt will be reorganized. The sovereign offers a bond exchange: Bond holders can change their defaulted bonds into new bonds with a lower coupon and principal.
The punishment will come in the shape reduced growth of country wealth. The reasons for the reduced growth are either direct trade sanctions in the Bulow and Rogoff sense, or the economic costs of lost reputation,in the debt market as well as spillover into other markets, i.e., the loss of the reputation as a trustworthy business partner. Furthermore, creditors can utilize the threat of litigation, i.e., the lenders will try to recuperate part of the principal by seizing assets of the sovereign held abroad.
The model itself is based on models of corporate credit risk, which are extended to incorporate features specific to sovereign credit risk and sovereign debt reorganization. It takes the idea of an endogenous bankruptcy rule as a flow condition from Kim, Ramaswamy and Sundaresan whose model has corporations defaulting when the firm does not generate enough cash flow to meet contractual coupon payments.
We begin by modeling the dynamics of the country’s wealth, incorporating debt service. Since it would be necessary to explicitly model the production side of the sovereign’s economy to estimate the cost of the defaulting and the benefit of the debt relief in case of default, or to at least assume an ad-hoc ‘utility’ function for the country, we will assume, following Bulow and Rogoff, that the sovereign seeks to maximize terminal country wealth, i.e., that it has a linear utility function. This assumption is limiting in the sense that we assume that there exists one utility function which describes the interests of the country. We do not allow, for instance, that the politicians in the government have interests different from the citizens of the country.
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