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Working Paper
Default and Interest Rate Shocks: Renegotiation Matters
We develop a sovereign default model with debt renegotiation in which interest-rate shocks affect default incentives through two mechanisms. The first mechanism, the standard mechanism, depends on how a higher interest rate tightens the government’s budget constraint. The second mechanism, the renegotiation mechanism, depends on how a higher rate increases lenders’ opportunity cost of holding delinquent debt, which makes lenders accept larger haircuts and makes default more attractive for the government. We use the model to study the 1982 Mexican default, which followed a large increase ...
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Default and Interest Rate Shocks: Renegotiation Matters
We develop a sovereign default model with debt renegotiation in which interest-rate shocks affect default incentives through two mechanisms. Under the standard mechanism, higher interest rates tighten the government’s budget constraint. Under the renegotiation mechanism, higher rates increase lenders’ opportunity cost of holding delinquent debt, which makes lenders accept larger haircuts and makes default more attractive for the government. We argue that our novel renegotiation mechanism reconciles standard sovereign default models with the narrative that the sharp increase in the real ...