Constrained Efficient Borrowing with Sovereign Default Risk

IMF Working Papers, November 8, 2020

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Using a quantitative sovereign default model, the paper characterizes constrained efficient borrowing by a Ramsey government that commits to income-history-contingent borrowing paths taking as given ex-post optimal future default decisions.
The Ramsey government improves upon the Markov government because it internalizes the effects of borrowing decisions in period t on borrowing opportunities prior to t.
The effect of borrowing decisions in t on utility flows prior to t can be encapsulated by two single dimensional variables.
Relative to a Markov government, the Ramsey government distorts borrowing decisions more when bond prices are more sensitive to borrowing, and when changes in bond prices have a larger effect on past utility.
In a quantitative exercise, more than 80% of the default risk is eliminated by a Ramsey government, without decreasing borrowing.
The Ramsey government has a higher probability of completing a successful deleveraging (without defaulting), while smoothing out the fiscal consolidation.

Commitment device: Ramsey government commits to income-history-contingent borrowing paths while taking ex-post optimal future default decisions as given.
Intertemporal internalization: Borrowing choices in period t affect borrowing opportunities prior to t; these effects are summarized by two single dimensional state variables.
Price sensitivity channel: Greater sensitivity of bond prices to borrowing amplifies the Ramsey–Markov divergence in borrowing distortions.
Past-utility channel: When changes in bond prices have larger effects on past utility, the Ramsey distortion of borrowing decisions increases relative to a Markov government.

More than 80% of the default risk is eliminated by a Ramsey government, without decreasing borrowing.
The Ramsey government increases the probability of successful deleveraging without default and smooths the required fiscal consolidation.