Decentralized borrowing and centralized default

In the past, foreign borrowing by developing countries was comprised almost entirely of government borrowing. However, private firms and individuals in developing countries now borrow substantially from foreign lenders. It is often asserted that this surge in private sector borrowing generates excessive borrowing and frequent sovereign defaults in developing countries. This paper analyzes the impact of decentralized borrowing using a quantitative model in which private agents decide how much to borrow and the government decides whether to default. Relative to a model in which the government determines both the level of borrowing and whether to default, decentralized borrowing drives up aggregate credit costs and sovereign default risk, and reduces aggregate welfare. Interestingly, decentralized borrowing may lead to either too much or too little debt in equilibrium depending on the severity of default penalties. (C) 2012 Elsevier B.V. All rights reserved.