We construct a dynamic equilibrium model with contingent service and adverse selection to quantitatively study sovereign debt. In the model, benefits of defaulting are tempered by higher future interest rates. For a wide parameter, the only equilibrium is one in which the sovereign defaults in all states; additional output losses, however, sustain equilibria that resemble the data. We show that due to the adverse selection problem, some countries choose to delay default in order to reduce loss of reputation. Moreover, although equilibria with no default imply in greater welfare levels, they are not sustainable in highly indebted and volatile countries.
Sovereign Debt as a Contingent Claim: A Quantitative Approach