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Private Debt with Pervasive Default Risk

Gao, Xiang (2009): Private Debt with Pervasive Default Risk.

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Abstract

This paper studies the effects of private debts on risk sharing and welfare, in which I assume individual residents have access to both international and domestic capital markets. Like Jeske (2006), I make the assumption that domestic residents cannot commit to repay their debts across border. The previous literature assumes contracts are perfectly enforceable within border, and hence the marginal rate of substitution must be equal among all residents in any one country. The novel feature in this model is to bring limited commitment into debt contracts signed between domestic residents. The pervasive risk of repudiation creates different domestic asset pricing rules for countries that are constrained in international financial market. Constrained country's domestic interest rate is equal to the reciprocal of the lowest marginal rate of substitution within that country. However, non-constrained countries still have equalized marginal rate of substitution which determines the international interest rate. A wider gap between domestic and international financing cost emerges in this model and leads to harsher punishment for international debt defaulters. Although limited domestic risk sharing hinders aggregate welfare reaching an even higher standard, it has no negative effect on the original level in Jeske's setup. As a result, my model allows more international risk sharing and higher welfare. I show how this improvement depends on the interaction between preventing within and across border default in equilibrium. I also explore the role of endogenous borrowing constraints, international borrowing by using other domestic residents as intermediaries and the specification of deviation penalty.

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