Creator: Arellano, Cristina and Bai, Yan Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 495 Abstract:
This paper studies an optimal renegotiation protocol designed by a benevolent planner when two countries renegotiate with the same lender. The solution calls for recoveries that induce each country to default or repay, trading off the deadweight costs and the redistribution benefits of default independently of the other country. This outcome contrasts with a decentralized bargaining solution where default in one country increases the likelihood of default in the second country because recoveries are lower when both countries renegotiate. The paper suggests that policies geared at designing renegotiation processes that treat countries in isolation can prevent contagion of debt crises.
Keyword: Sovereign default, Contagion, and Renegotiation policy Subject (JEL): F30 - International Finance: General and G01 - Financial Crises