Borrowing in excess of natural ability to repay

• Published in: Review of Economic Dynamics Vol. 23; pp. 42 - 59
• Main Authors: Martins-da-Rocha, V. Filipe, Vailakis, Yiannis
• Format: Journal Article
• Language: English
• Published: Elsevier 01.01.2017
• Subjects: Economics and Finance; Humanities and Social Sciences; Limited Commitment; Natural Debt Limit; Self-enforcing Debt
• ISSN: 1094-2025; 1096-0929
• DOI: 10.1016/j.red.2016.09.006

The paper aims at improving our understanding of self-enforcing debt in competitive dynamic economies with lack of commitment when default induces a permanent loss of access to international credit markets. We show, by means of examples, that a sovereign's creditworthiness is not necessarily limited by the ability to repay out of its future resources. Self-enforcing debt grows at the same rate as interest rates. If a sovereign's endowment growth rates are lower than interest rates, then debt limits eventually exceed the natural debt limits. This implies that there is asymptotic borrowing in present value terms. We show that this can be compatible with lending incentives when credible borrowers facilitate inter-temporal exchange, acting as pass-through intermediaries that alleviate the lenders' credit restrictions.