A Cooperative Perspective on Sovereign Debt: Past and Present

I. INTRODUCTION The current Asian financial crisis reminds us of analogous situations occurring not long ago. In the 19th and the early 20th centuries, the sovereign debt issue was a destabilizing factor in the international financial market. Likewise, the Third World debt crisis in the 1980s has affected the world economy critically. On August 12, 1982, the announcement that Mexico could not continue to service its huge foreign debt triggered a decade-long international financial crisis. This debt crisis seriously hurt the international financial system and dampened the world economy. There were hundreds of commercial banks and dozens of sovereign states (Buchheit, 1991) engaged in several hundred billion sovereign debts (Wesberry, 1983). For the nine American money-center banks involved, the stake was about 280% of their capital (Cline, 1985). This event drew the attention of numerous researchers because of the voluminous debts and the world's inexperience in coping with such a global crisis. Due to the large sum of the debt and the lack of coordination among the members of the international community, debtor countries and creditor banks had to negotiate constantly over rescheduling of old debts and refinancing of new loans. Creditor banks, debtor countries, and the international community all failed to realize that a debt this large cannot be paid off in a short period of time. In most of the literature concerning the debt crisis, researchers have relied on bargaining games in which creditors and debtors can make offers to each other in a non-cooperative setting. The reputation of being a good debtor or a tough creditor plays a role in explaining research results. As debtors' economies worsened, researchers shifted their attention to the effect of debt overhang, the burden of adjustment, and the alternatives of forgiving the debts (Bulow and Rogoff, 1991). These issues are crucial and deserve analysis. However, considering a cooperative approach is equally important since efficiency is socially desirable and, as history has shown, such a goal is attainable. In addition, such an approach makes qualitatively clear the relationships among the variables we are interested in, which in turn provides us valuable guidelines in how to achieve efficiency. Our models extend Krugman's (1985) framework by using the Nash bargaining solution, searching for an efficient and cooperative settlement. The cooperative outcome shows that the initial debt and new loans are positively related, while the remaining debt and the interest rate are negatively related. Achieving the cooperative outcome is not easy, however. The long-term advantage of committing to repayment is not unfamiliar to sovereign borrowers, but the temptation of reneging is difficult to resist, in particular when fiscal crises are in sight. Nevertheless, we find a cooperative episode in history: the financial evolution of England after the Glorious Revolution. This episode matched the results in our models. That is, the amount of available credit increased dramatically and lending rates dropped, after the king and Parliament reached a cooperative solution. What interests us is not only the financial evolution of England, but also how the financial institutions were formed and how we can achieve the same result in our time, especially when Asia is experiencing financial crisis. By institutions we mean the rules of a game (North, 1991) - in this case, the norms regulating borrowers and lenders. Due to the limit of space, we will pursue a model that can make sovereign debt self-enforcing elsewhere. II. THE COOPERATIVE FRAMEWORKS(1) The bargaining game between two parties has long been an important field in economic research. Rubinstein (1982) offers a non-cooperative bargaining framework in which players make offers to each other in alternation. Bulow and Rogoff (1989a,b) adopt Rubinstein's model to discuss the negotiation among the parties involved in the Third World debt crisis. …