Optimal sovereign default

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URL:	https://ub-madoc.bib.uni-mannheim.de/32508
URN:	urn:nbn:de:bsz:180-madoc-325087
Document Type:	Working paper
Year of publication:	2012
The title of a journal, publication series:	Working Paper Series
Volume:	12-16
Place of publication:	Mannheim
Publication language:	English
Institution:	School of Law and Economics > Geldpolitik und Makroökonomik (Adam 2008-)
MADOC publication series:	Department of Economics > Working Paper Series
Subject:	330 Economics
Classification:	JEL: E62 , F34,
Abstract:	When is it optimal for a government to default on its legal repayment oblig- ations? We answer this question for a small open economy with domestic production risk in which the government optimally finances itself by issuing non-contingent debt. We show that Ramsey optimal policies occasionally devi- ate from the legal repayment obligation and repay debt only partially, even if such deviations give rise to significant default costs. Optimal default improves the international diversification of domestic output risk, increases the efficiency of domestic investment and - for a wide range of default costs - significantly increases welfare relative to a situation where default is simply ruled out from Ramsey optimal plans. We show analytically that default is optimal following adverse shocks to domestic output, especially for very negative international wealth positions. A quantitative analysis reveals that for empirically plausible wealth levels, default is optimal only in response to disaster-like shocks to do- mestic output, and that default can be Ramsey optimal even if the net foreign asset position is positive.