We consider a model of international sovereign debt where repayment is enforced because defaulting nations lose their reputation and consequently, are excluded from international capital markets. Underlying the analysis of reputation is the hypothesis that borrowing countries have different, unobservable, attitudes towards the future. Some regimes are relatively myopic, while others are willing to make sacrifices to preserve their access to debt markets. Nations' preferences, while unobservable, are not fixed but evolve over time according to a Markov process. We make two main points. First we argue that in models of sovereign debt the length of the punishment interval that follows a default should be based on economic factors rather than being chosen arbitrarily. In our model, the length of the most natural punishment interval depends primarily on the preference parameters. Second, we point out that there is a more direct way for governments to regain their reputation. By offering to partially repay loans in default, a government can signal its reliability. This type of signaling can cause punishment interval equilibria to break down. We examine the historical record on lending resumption to argue that in almost all cases, some kind of partial repayment was made.

In this paper we will consider a simple small open economy with three assets - domestic capital, foreign securities and public debt - to study the government's incentives to devalue and to repay or default the debt. We show that the announcement of a devaluation is anticipated by domestic agents who reduce domestic investments and increase foreign holdings. Once a government devalues, the expectations vanish and the economy recovers its past levels of investment and GDP. However, in a country with international debt denominated in US dollars if a government devalues it requires a higher fraction of GDP to repay its external debt. In consequence, there exists a trade-off between recovering the economy and increasing the future cost of repaying the debt. Our main result is to show that, as devaluation beliefs exists, a devaluation increase government incentives to default and devalue. We calibrate our model to match the decrease in investment of domestic capital, the reduction in production, the increase in trade balance surplus, and the increase in debt levels observed throughout 2001 in Argentina. We show that for a probability of devaluation consistent with the risk premium of the Argentinian Government bonds nominated in dollars issued on April 2001 the external debt of Argentina was in a crisis zone were the government find optimal to default and to devalue.