Sovereign debt crises and cross-country assistance

Abstract

We provide a parsimonious framework to study the interplay between cross-country assistance and expectations-driven sovereign debt crises. Our framework extends the traditional single-country model of how multiple perfect-foresight equilibria are possible when a sovereign attempts to service public debt. The extension is that a self-interested ‘safe’ country may choose to assist a ‘risky’ country which is prone to default. Investors internalize the potential for assistance when lending to fragile countries. If the safe country cannot commit to fixed cross-country transfers or rule them out completely, assistance improves equilibrium outcomes only if the risky country is fundamentally insolvent in the sense that it cannot repay existing debt at the risk-free interest rate. If a default requires pessimistic expectations, an incentive-compatible (IC) assistance policy has adverse side effects.