Staff Report 495

Renegotiation Policies in Sovereign Defaults

Cristina Arellano | Monetary Advisor
Yan Bai

Published January 10, 2014

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.

Forthcoming In: American Economic Review Papers and Proceedings

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