Default and interest rate shocks: Renegotiation matters

Abstract

We develop a sovereign default model with endogenous re-entry to financial markets via debt renegotiation. We use this model to evaluate how shocks to risk-free interest rates trigger default episodes through two channels: borrowing costs and expected renegotiation terms after default. The first channel makes repayment less attractive when risk-free interest rates are high due to higher borrowing costs. The second channel works through the expected subsequent renegotiation process: when risk-free rates are high, lenders are willing to accept a higher haircut in exchange for resuming payments. Thus, high risk-free rates imply better renegotiation terms for a borrower, making default more attractive ex-ante. We calibrate the model to study the 1982 Mexican default, which was preceded by a drastic increase in federal funds rates in the US. We find that the renegotiation process is key for reconciling the model to the widespread narrative that the increase in US interest rates triggered the 1982 default episode.