SOVEREIGN DEBT AND THE LONDON-CLUB - A PRECOMMITMENT DEVICE FOR LIMITING PUNISHMENT FOR DEFAULT

In this paper, we examine the role that institutions may play in enabl ing banks to write contracts whereby sovereign debt is not forgiven ex post. Our model provides a rationale for the emergence of a centraliz ed forum for debt renegotiation, such as the London Club, as well as f or bank syndicates. These bank syndicates arise as part of a pre-commi tment device rather than for risk sharing purposes. We propose a debt contract under which only involuntary default is forgiven ex post. Our main findings are that under this contract, debt forgiveness after vo luntary (strategic) default is avoided. When voluntary default occurs, access to the credit market is denied only for a limited number of pe riods, rather than forever. In contrast to a voluntary default, involu ntary default is forgiven immediately.