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Sovereign Bailouts and Moral Hazard with Strategic Default

Perazzi, Elena (2020): Sovereign Bailouts and Moral Hazard with Strategic Default.

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Abstract

Do bailouts create moral hazard, even when they come in the form of loans that do not involve any debt relief component? And what is the rationale for imposing ex-ante conditionality in terms of fiscal policy? I address these questions in a model of strategic severeign default, in which a debt crisis occurs after a bad fundamental shock. The market's willingness to lend is limited by the inability of the government to commit to future repayment; the government may decide to default although it would be willing to repay if it was able to borrow more and commit to repay. An International Financial Institution (IFI) is able to enforce repayment, and can therefore bail out the government by lending more than the markets are willing to do. I show that, if the IFI is ready to step in, markets lend more at lower spreads, and governments collect lower fiscal surplus and accumulate more debt. In a numerical example calibrated to Argentina, I show that, although the incidence of default is reduced in the presence of the IFI, bailouts are frequent and inevitable unless bailout access is subject to conditionality.

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