## Constrained Efficient Borrowing with Sovereign Default Risk

_IMF Working Papers, November 8, 2020_

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**Canonical URL:** [Constrained Efficient Borrowing with Sovereign Default Risk](https://www.imf.org/en/publications/wp/issues/2020/11/08/constrained-efficient-borrowing-with-sovereign-default-risk-49824)

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## Bibliographic details
- Authors: Juan Carlos Hatchondo, Leonardo Martinez, Francisco Roch
- Published: November 8, 2020
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513560366.001

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### Summary
- 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.

### Model insights and mechanisms
- 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.

### Quantitative findings
- 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2020/11/08/constrained-efficient-borrowing-with-sovereign-default-risk-49824_