A Valuation Model for Developing-Country Debt with Endogenous Rescheduling

Creditors have little recourse if a sovereign state repudiatesits external debt obligations. They can, however, threaten toimpose penalties if such action occurs which results in deadweightlosses to the system as a whole. A preferred alternative forboth borrower and lender is to recontract debt obligations.Reschedulings are a device that creditors can use to structurethe incentives faced by borrowers such that repudiation is nevera rational action. This article develops a numerical method of valuing the optionto reschedule. The model shows why fees are preferred to higherinterest spreads during a rescheduling exercise; why maturitiesget shorter prior to a debt crisis but are lengthened in therescheduling; why tougher supervision by regulatory authoritiescould be damaging to renewed voluntary loans; and why littlehas been done to attempt to seize the assets of countries thathave not repaid any interest or principal for extended periodsof time. The model shows that lenders are willing to commit greater amountsif reschedulings are possible than if they are not, and thatprecommitment to provide additional funds at rescheduling canraise the market value of existing debt and should not be construedas concessions by commercial lenders. Alternately, the modelcan be used to improve systems for ranking country creditworthiness,to assess the degree of adjustment required to spark a fullresumption of spontaneous lending, or to estimate by how muchinterest rates would have to fall to restore a country's creditworthiness.