IMF Staff Papers, Vol. 51, Special Issue, 2004: New Empirical Results on Default: A Discussion of A Gravity Model of Sovereign Lending: Trade, Default and Credit by Mark L.J. Wright

Sovereign default, while by no means ubiquitous, is still all too common. Moreover, as illustrated in Figure 1, sovereign debt crises, in which multiple debtor countries get into payments difficulties at roughly the same time, occur with surprising regularity. When this is combined with the fact that defaults appear to be very costly, to both the creditors who lose money on their investments and also to the defaulting country itself, it is natural that discussion turns to questions such as if and how the international financial system might be “reformed” to minimize the incidence and costs of these crises. However, before policymakers can talk sensibly about “reforming the international financial architecture,” it is necessary that they have a clear understanding of both the incentives faced by creditors and defaulting countries, and the ways in which institutions and governments affect these incentives. In this regard, economists have developed no shortage of interesting and clever theories, both formal and informal, of the incentives governing the default process. Much has been written about the incentives of defaulting countries to repay their debts, and about the punishments creditors can use to deter default, including the use of legal sanctions since the passage of the (U.S.) Foreign Sovereign Immunities Act in 1976, the loss of access to credit markets (the so-called “reputation” models of Eaton and Gersovitz, 1981, and many others), the loss of a country’s reputation