Volatility and Sovereign Default

The history of international lending shows that countries default on external debt when their economies experience a downturn. This paper presents a theoretical model of international lending that is consistent with this evidence. In this model, output is stochastic, international capital markets are incomplete because borrowing can only occur via issuing bonds, and borrowers cannot commit to repay loans. Self-fulfilling and solvency debt crises arise when borrowers experience low output realizations; moreover, when lenders are atomistic, self- fulfilling crises may arise for debt levels that do not cause default when lenders are non-atomistic. Alternative reforms to eliminate liquidity crises are analyzed. An international lender of last resort can eliminate liquidity crises provided it implements full bailouts via purchasing debt at its market price.