Sovereign Default with Unobservable Physical Capital

We develop a model of sovereign default where borrowers’ physical capital is not observable by the lenders and therefore the bond price schedule does not depend on capital accumulation. Borrowers take decisions on consumption, investment in physical capital, international assets, and whether to honor previous debt contracts (thus having an option to default). We calibrate the model on the Argentine economy and simulate the effects of productivity shocks. We compute the dynamics of equilibrium bond prices, physical capital, debt and consumption in addition to equilibrium default. We find that borrowing for consumption and investment is an optimal outcome, even if capital is unobservable, but differently from the literature with observable capital, countries do not over invest. Our results can inform international debt policies and con ditionality clauses under imperfect information on borrowers’ capital.