Competition and Intervention in Sovereign Debt Markets

40 Pages Posted: 10 Jun 2002

See all articles by Bernhard Paasche

Bernhard Paasche

affiliation not provided to SSRN

Stanley E. Zin

Carnegie Mellon University; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 2001

Abstract

We investigate markets for defaultable sovereign debt in which even though there are many identical lenders and symmetric information (including no hidden actions), perfect competition does not obtain. When a private lender allows a sovereign country to increase its level of indebtedness, that lender implicitly imposes a default externality on others who have lent to that sovereign. That is, in the case where the borrower would be able to pay back the first loan in the absence of a second loan, the borrower may have a strong incentive to take both loans and default on both loans. When a lender has no control over the actions of other lenders, they must anticipate this behavior and devise a lending strategy that is consistent with the strategies not only of the sovereign borrower, but also of other lenders. We develop a model of this strategic lending behavior in the presence of default, and show that even though there are many competing lenders, the perfectly competitive outcome does not necessarily obtain. Moreover, the equilibrium can result in monopoly-like outcomes in prices and quantities. The equilibrium in these types of markets depends critically on the fraction of income that the sovereign can retain in the case of default, and on the distribution of random productivity shocks that governs default probabilities. We solve for conditions under which monopoly outcomes can be sustained as symmetric equilibria even when the number of lenders is large. We also study the consequences of intervention in these markets by a seemingly benevolent international financial institution, and find that these interventions, though well-intentioned, can in some cases be welfare reducing for sovereign countries and welfare improving for private lenders.

Keywords: sovereign debt, bond pricing, monopolistic competition, IMF, default

JEL Classification: F33, E44, G15, G12

Suggested Citation

Paasche, Bernhard and Zin, Stanley E., Competition and Intervention in Sovereign Debt Markets (October 2001). Available at SSRN: https://ssrn.com/abstract=315362 or http://dx.doi.org/10.2139/ssrn.315362

Bernhard Paasche (Contact Author)

affiliation not provided to SSRN

No Address Available

Stanley E. Zin

Carnegie Mellon University ( email )

Pittsburgh, PA 15213-3890
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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