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Optimal Sovereign Default

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  • Adam, Klaus

Abstract

When is it optimal for a government to default on its legal repayment obligations? We answer this question for a small open economy with domestic production risk in which the government optimally fi?nances itself by issuing non-contingent debt. We show that Ramsey optimal policies occasionally deviate from the legal repayment obligation and repay debt only partially, even if such deviations give rise to signi?cant ?default costs?. Optimal default improves the international diversi?cation of domestic output risk, increases the efficiency of domestic investment and - for a wide range of default costs - signi?cantly increase welfare relative to a situation where default is simply ruled out from Ramsey optimal plans. We show analytically that default is optimal following adverse shocks to domestic output, especially for very negative international wealth positions. A quantitative analysis reveals that for empirically plausible wealth levels, default is optimal only in response to disaster-like shocks to domestic output, and that default can be Ramsey optimal even if the net foreign asset position is positive.

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  • Adam, Klaus, 2012. "Optimal Sovereign Default," CEPR Discussion Papers 9178, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:9178
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    Cited by:

    1. Thomas McGregor, 2019. "Pricing Sovereign Debt in Resource-Rich Economies," IMF Working Papers 2019/240, International Monetary Fund.
    2. Stefan Niemann & Paul Pichler, 2017. "Collateral, Liquidity and Debt Sustainability," Economic Journal, Royal Economic Society, vol. 127(604), pages 2093-2126, September.
    3. Jeromin Zettelmeyer & Christoph Trebesch & Mitu Gulati, 2013. "The Greek debt restructuring: an autopsy [Greek bond buyback boondoggle]," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 28(75), pages 513-563.
    4. Sosa-Padilla, César, 2018. "Sovereign defaults and banking crises," Journal of Monetary Economics, Elsevier, vol. 99(C), pages 88-105.
    5. Thomas McGregor, 2017. "Pricing sovereign debt in resource rich economies," OxCarre Working Papers 194, Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford.
    6. Falko Juessen & Andreas Schabert, 2013. "Fiscal Policy, Sovereign Default, and Bailouts," Working Paper Series in Economics 67, University of Cologne, Department of Economics.
    7. Xuan Wang, 2019. "When Do Currency Unions Benefit From Default ?," 2019 Papers pwa938, Job Market Papers.
    8. Trebesch, Christoph & Zabel, Michael, 2017. "The output costs of hard and soft sovereign default," European Economic Review, Elsevier, vol. 92(C), pages 416-432.
    9. Stefan Niemann & Paul Pichler, 2020. "Optimal fiscal policy and sovereign debt crises," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 37, pages 234-254, July.
    10. repec:onb:oenbwp:y:2013:i:187:b:1 is not listed on IDEAS
    11. Xuan Wang, 2021. "Bankruptcy Codes and Risk Sharing of Currency Unions," Tinbergen Institute Discussion Papers 21-009/IV, Tinbergen Institute.
    12. Mr. Michael Kumhof & Mr. Romain Ranciere & Pablo Winant, 2013. "Inequality, Leverage and Crises: The Case of Endogenous Default," IMF Working Papers 2013/249, International Monetary Fund.
    13. Toan Phan & Felipe Schwartzman, 2023. "Climate Defaults and Financial Adaptation," Working Paper 23-06, Federal Reserve Bank of Richmond.
    14. Joost Rцttger, 2014. "Monetary and Fiscal Policy with Sovereign Default," Working Paper Series in Economics 74, University of Cologne, Department of Economics.
    15. repec:esx:essedp:730 is not listed on IDEAS
    16. Stefan Niemann & Paul Pichler, 2020. "Optimal fiscal policy and sovereign debt crises," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 37, pages 234-254, July.
    17. Daniel, Betty C. & Nam, Jinwook, 2022. "The Greek debt crisis: Excusable vs. strategic default," Journal of International Economics, Elsevier, vol. 138(C).
    18. Rieth, Malte, 2014. "Myopic governments and welfare-enhancing debt limits," Journal of Economic Dynamics and Control, Elsevier, vol. 38(C), pages 250-265.
    19. Fabrice Collard & Michel Habib & Jean-Charles Rochet, 2015. "Sovereign Debt Sustainability In Advanced Economies," Journal of the European Economic Association, European Economic Association, vol. 13(3), pages 381-420, June.
    20. Demian Pouzo & Ignacio Presno, 2020. "Optimal Taxation with Endogenous Default under Incomplete Markets," International Finance Discussion Papers 1297, Board of Governors of the Federal Reserve System (U.S.).
    21. Rieth, Malte, 2017. "Capital taxation and government debt policy with public discounting," Journal of Economic Dynamics and Control, Elsevier, vol. 85(C), pages 1-20.
    22. Roettger, Joost, 2019. "Discretionary monetary and fiscal policy with endogenous sovereign risk," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 44-66.
    23. Chen, Hsien-Yi & Chen, Sheng-Syan, 2018. "Quality of government institutions and spreads on sovereign credit default swaps," Journal of International Money and Finance, Elsevier, vol. 87(C), pages 82-95.
    24. Dooyeon Cho & Dong‐Eun Rhee, 2024. "Determinants of market‐assessed sovereign default risk: Macroeconomic fundamentals or global shocks?," International Finance, Wiley Blackwell, vol. 27(1), pages 35-60, April.

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    More about this item

    Keywords

    Incomplete markets; Optimal default; Ramsey optimal fiscal policy;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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