Geogebra 35

African countries is increasingly cited as having a potentially debilitating effect on debt enforcement (e.g. see the Financial Times article by Beattie and Callan, 2006).

repaym ent w ou ld be assured by setting the constraint just below the cost of default.

W ith country risk equal to zero, lending w ould take place at w orld interest prices. In

the presence of uncertainty, how ever, the cost of default is unknow n. K rugm an

(1985) dem onstrates th at a credit constraint persists even in equilibrium . Assum e, for

example, th at the enforceable penalty consists of the seizure of the defaulter's foreign

trade receipts, w hich in tu rn depends on export volum es and prices. The overall cost

associated w ith the penalty will then be uncertain: for exam ple, it m ay be low er than

expected if an unanticipated shortfall in either export volum es or a w orsening in the

term s of trad e occurs. Hence, K rugm an (1985) concludes th a t lenders w ould react to

this uncertainty by charging a risk prem ium to highly indebted countries, as they are

m ore likely to default. H igher interest rates in tu rn increase the expected future debt

bu rden, causing excess dem and for credit (i.e. a credit constraint) to persist in

equilibrium . The crucial message, echoed by m ost of the sovereign d ebt literature, is

th at in the presence of an incentive constraint, a first-best allocation of resources is

rarely attainable.

In sum, the sovereign debt literature show s that bo th repaym ent capacity and

incentive com patibility constrain a sovereign's borrow ing. As to w hich constraint is

m ore binding, this depends on the enforcem ent m echanism at the disposal of the

creditors. W ith perfect enforcem ent only capacity to p ay m atters. O therw ise, a

debtor's rep ay m ent incentive will bind, w hich in tu rn determ ines the credit

constraint im posed by the creditors. A lthough w illingness to pay is a necessary

condition for repaym ent of debt by a sovereign to occur, it is n o t sufficient: first and

foremost, a country m u st have the financial capacity to service its debts. Therefore, to

determ ine the ap propriate policy-response to a debtor's m anifested inability to repay,

creditors are first required to assess the debtor's state of solvency. Indeed, a country

m ay m erely be suffering a tem porary shortage of cash, or a m ore severe problem that

is also likely to debilitate repaym ents in future periods. A central th ru st of the

sovereign debt literature thus lies in defining the optim al response by creditors on

the basis of the illiquidity-insolvency dichotom y, w hich is form ally outlined in the

2.3 Illiquidity versus insolvency, and the concept of debt sustainability

D raw ing on the stan d ard m odels from the sovereign deb t literature, this section

defines the so-called solvency or transversality condition, distinguishing illiquid

from insolvent borrow ers. W e show that such distinction is essentially im possible to

m ake in the presence of uncertainty about a debtor country's future stream of income

or repaym ent capacity, since it is partly determ ined by factors outside its control.

Consequently, the em phasis typically placed on the distinction betw een lending

versus adjustm ent requirem ents on the grounds of a debtor country's degree of

solvency is largely m isleading and suboptim al. Indeed, u n d er conditions of

uncertainty, creditors' choice of optim ising actions in response to a debtor in

apparent distress will largely d epen d on their ow n subjective assessm ent and

expectations regarding its state of insolvency, and thus assum e a self-fulfilling

character. Essentially, it will be show n that the potential suprem acy of state-

contingent contracts is argu ed on the grounds of this fundam ental indeterm inacy

problem relating to a sovereign d ebtor's solvency, w hich abstracts from the

illiquidity-insolvency dichotom y typically referred to.

Borrowing from C ohen and Katseli (1985) and K rugm an (1988a), w e set out to state

the solvency condition m ore rigorously, assum ing first th at there is no uncertainty

about a debtor country's future incom e stream . Consider an indebted country, w hich

services debt out of current export revenues.13 Further assum e that the country's rate

of grow th of export value exceeds the interest rate it pays on ou tstand ing debt. Since

the am ount devoted to repay m ent w ou ld grow at a higher rate than the outstanding

debt itself how ever sm all a fixed fraction of export proceeds the country w ere to

allocate to the repaym ent of debt, it w ould always be sufficient to repay the

ou tstanding debt in full by some finite date L By the m easure of the p resent value of

export earnings over time, the country's gross (external) w ealth w ould be infinite,

13 Depending on whether the focus of analysis is more on the internal or the external transfer problem