Optimal Sovereign Debt Relief and Exclusion with Unobservable Physical Capital

We investigate the optimum lending arrangements when there is the possibility of partial default, in addition to full default when physical capital is unobservable. In a model calibrated on Argentina, we find an optimal debt reduction of 39%, and optimal re-entry probability of 0.10. Full default is more likely when total factor productivity is very low, and either debt is low or very high. Partial default is more likely when debt is moderate. Monte Carlo simulations under the optimum lending arrangements indicate the economy spends 47.90% of the time in partial default, translating into an average partial default probability of 9.12%. This is quantitatively close to what emerging economies have experienced, thus suggesting that current arrangements are close to optimal. In fact, if there is a competitive market for borrowers, we would expect risk-neutral lenders to offer schemes giving higher utility to the borrower, and thus the competitive market should converge to the optimal scheme.