Efficient Sovereign Default
The Review of Economic Studies
Volume 86, Issue 1, January 2019, Pages 282–312
In this article, I show that the key aspects of sovereign debt crises can be rationalized as part of the efficient risk-sharing arrangement between a sovereign borrower and foreign lenders in a production economy with informational and commitment frictions. The constrained efficient allocation involves ex post inefficient outcomes that resemble sovereign default episodes in the data and can be implemented with non-contingent defaultable bonds and active maturity management. Defaults and periods of temporary exclusion from international credit markets happen along the equilibrium path and are essential to supporting the efficient allocation. Furthermore, during debt crises, the maturity composition of debt shifts towards short-term debt and the term premium inverts as in the data.