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Decentralized Borrowing and Centralized Default
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Abstract
In the past, foreign borrowing by developing countries was comprised almost entirely of government borrowing. Recently, private firms and individuals in developing
countries borrow substantially from foreign lenders. It is not clear whether the observed
increase in private sector borrowing leads to overborrowing and frequent defaults by
governments in developing countries. In this paper, we develop a tractable quantitative
model in which private agents decide how much to borrow but the government decides whether to default. The model with decentralized borrowing increases aggregate credit
costs and sovereign default risk, and reduces aggregate welfare, relative to a model with
centralized borrowing. Private agents do not internalize the effect of their borrowing on economy-wide credit costs and thus would like to borrow more than the socially efficient level. Depending on the severity of default penalties, decentralized borrowing
may lead to either too much or too little debt in equilibrium. The introduction of
decentralized borrowing substantially improves the model's empirical fit in terms of matching observed debt levels and default rates.Sovereign Default, Sovereign Debt, Private Borrowing, Capital Flows