A Model of Sovereign Borrowing and Sovereign Yield Spreads

In a continuous-time setting, we model the problem of sovereign borrowing. In our model, borrowing is used to generate exports. The sovereign borrower in our model is subject to two types of potential retaliatory actions from the lender in the event of default. First, the lender can capture a part of production in the event of default. Second, the lender can impose trade sanctions in the spirit of Bulow and Rogoff (1989a). Such sanctions reduce the flow rates of future output of the domestic production in this model. The borrower takes these potential actions into account in the choice of optimal voluntary default and the optimal debt level.The sovereign loan contract differs from an otherwise identical corporate debt contract in our model by the fact that the latter is protected by the bankruptcy code which gives a better access to the collateral of the borrower. This difference alone is sufficient to cause the optimal default strategies to differ significantly for sovereign contracts as compared to corporate debt. The sovereign debt is renegociated more often and yield spreads between sovereign and corporate debt can be as high as 25 basis points. If after borrowing, the fortunes of the borrowing country were to decline, there will be a debt overhang. We show that this problem is mitigated by renegotiated reductions in the debt service payments