International financial architecture and strategic default: can financial crises be less painful?

Abstract

Recent financial crises in emerging markets have been followed by temporary but substantial losses in output. This paper explores the possibility that threats of such losses are the dominant incentive for repayment of international debt. In this environment private debtors and creditors have strong incentives to design international contracts so that renegotiation is costly. Such contracts generate dead weight losses following crises. Proposals to modify contractual arrangements, or to facilitate or impose renegotiation, can be welfare-improving under special circumstances. However, it is likely that such proposals would also weaken the incentives that make private international debt possible.