Capital Flows, Default, and Renegotiation in a Small Open Economy

Peiris, Udara, Sokolova, Anna and Tsomocos, Dimitrios (2017) Capital Flows, Default, and Renegotiation in a Small Open Economy. Saïd Business School Working Paper.

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The post-2008 period focused attention on "twin-crises". Banking crises may lead to sovereign crises where fiscal vulnerabilities are exacerbated by the extension of support for the banking system. We develop a model that describes private sector generated capital inflow that is used to finance investment and consumption expenditure. In the event of an economic contraction, the (convex) haircut on outstanding debt is negotiated, or bargained, centrally by the sovereign. Two results arise: the volume of debt and haircut rate are inefficient. In this setting the accumulation of capital achieves two goals. First, it generates sufficient optimism about future income to allow the debt market to function. Second, and counter-intuitively, it increases expected haircuts by raising the value of the outside option of complete default. These competing forces characterize the optimal balanced-budget macroprudential policy targeting capital investment.

Item Type: Oxford Saïd Research Paper
Keywords: open economy, capital flows, debt, default, renegotiation
Subject(s): Economics
Date Deposited: 02 Feb 2017 16:40
Last Modified: 21 Sep 2018 15:03
Funders: n/a

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