This project seeks to develop a theory of debt overhang and debt buyback. Sovereign nations frequently accumulate substantial debts. A nation's debt often exceeds the amount the nation is willing to repay, a situation known as debt overhang. A nation that is unwilling to repay everything it owes either defaults on the debt or negotiates with its creditors to reduce the debt in a buyback. Empirical evidence suggests that buybacks occur far more frequently than defaults; heavily indebted countries can greatly reduce their debts in negotiations without defaulting. The Highly Indebted Countries at the end of the 1980s are a famous example. These countries owed approximately $300 billion to commercial banks and governments, but the outstanding debt decreased to less than $100 billion after a buyback.
This project's first step is to develop simple theoretical frameworks describing how nations accumulate and renegotiate debt. The project plans to model the relationships between borrowers and lenders as dynamic games in infinite discrete time. The project identifies various reasons why countries borrow in the first place, such as illiquidity and consumption smoothing. The project also considers several scenarios explaining debt accumulation. For example, the borrower may have a random technology and be unable to arrange contracts contingent on the technology shocks. The project intends to fully characterize the structures of financial contracts in such environments.
The next step is to develop models that not only yield interesting insights but also generate quantitatively serious predictions. To this end, this research will enrich the simple frameworks to approximate real economies. These more complicated models will then be calibrated and their implications empirically tested. This project will have a broader impact along several dimensions. First, the project describes clearly the environments in which debt overhang may occur. Second, the results make precise predictions about the size of a negotiated debt reduction as a function of debt, income, and the production technology. Third, the frameworks developed by the Principal Investigator make it possible to analyze the role of international lending institutions such as the International Monetary Fund and the World Bank. Can these institutions improve social welfare by intervening? And if they can, what policies should they follow? Fourth, default and debt overhang in the context of sovereign countries are closely related to bankruptcies and liquidations in the corporate sector. Developments in one area have immediate spillovers in the other. Finally, the proposed research will yield new mathematical tools that should be useful in analyzing a general class of dynamic games.
