A Valuation Model for Developing-Country Debt with Endogenous Rescheduling

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Abstract
Creditors have little recourse if a sovereign state repudiates its external debt obligations. They can, however, threaten to impose penalties if such action occurs which results in deadweight losses to the system as a whole. A preferred alternative for both borrower and lender is to recontract debt obligations. Reschedulings are a device that creditors can use to structure the incentives faced by borrowers such that repudiation is never a rational action. This article develops a numerical method of valuing the option to reschedule. The model shows why fees are preferred to higher interest spreads during a rescheduling exercise; why maturities get shorter prior to a debt crisis but are lengthened in the rescheduling; why tougher supervision by regulatory authorities could be damaging to renewed voluntary loans; and why little has been done to attempt to seize the assets of countries that have not repaid any interest or principal for extended periods of time. The model shows that lenders are willing to commit greater amounts if reschedulings are possible than if they are not, and that precommitment to provide additional funds at rescheduling can raise the market value of existing debt and should not be construed as concessions by commercial lenders. Alternately, the model can be used to improve systems for ranking country creditworthiness, to assess the degree of adjustment required to spark a full resumption of spontaneous lending, or to estimate by how much interest rates would have to fall to restore a country's creditworthiness.

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