We provide benchmarks to evaluate what is an optimal foreign debt and a maximal foreign debt (debt-max), when risk is explicitly considered. When the actual debt exceeds debt-max, then the economy will default when a "bad shock" occurs. This paper is an application of the stochastic optimal controls models of Fleming and Stein (2001), which gives empirical content to the question of how one should measure "vulnerability" to shocks, when there is uncertainty concerning the productivity of capital. We consider two sets of high-risk countries during the period 1978-99: a subset of 21 countries that defaulted on the debt, and another set of 13 countries that did not default. Default is a situation where the firms or government of a country reschedule the interest/principal payments on the external debt. We thereby explain how our analysis can anticipate default risk, and add another dimension to the literature of early warning signals of default/credit risk. Copyright 2001 by Blackwell Publishers Ltd/University of Adelaide and Flinders University of South Australia
