SEMINAR 26 November 2012: Mario R.C. Bersem, Copenhagen Business School

Incentive-Compatible Sovereign Debt

Abstract

This paper extends the well-known costly state verification (CSV) approach in financial contracting to a setting without a court. Specifically, I present a model of sovereign borrowing where information is asymmetric, verification is costly, and there is no direct enforcement of repayment promises. Instead, economic and political sanctions motivate the government to repay. In this setting I show that the sovereign optimally issues a debt contract that pays a fixed amount in high income states, and that specifies a verification cum debt renegotiation (i.e. a default) in low income states. Defaults are politically costly, which reduces the government’s incentives to default strategically. Creditors also take a loss; their repayment in default is commensurate with the economic sanctions they can impose. The interest rate on sovereign debt decreases if political or economic sanctions can be increased: sanctions act as indirect enforcement mechanisms and reduce sovereign risk.