One could think of period-two values as the present discounted value (i.e a stock) of all future disbursement and repayment streams (i.e flows).

18 N ote that repayment capacity, i.e. the maximum resource transfers to creditors, is assumed to be given. The bargaining problem between debtors and creditors about the amount of resource transfers will be considered below. Here it is sufficient to assume that resource transfers in each period are equal to the maximum amount of resources available to a country for the purpose of debt servicing, minus a fraction reserved to maintain a minimum subsistence level.

xi+X2/(l+r)<D, creditors know they will not be p aid back th e full am ount of new

lending, and therefore refuse to lend at any level of interest. C reditors reckon th a t the

problem is one of insolvency, since outstanding debt cannot possibly be repaid, and

are left w ith no choice other than to forgive p art of ou tstanding debt. D ebt relief then

takes the form of either reduced principal (lowering Do), or redu ced rate of interest

(on Do and /o r Do-xi), or a com bination of the two. In sum, w ith no uncertainty about

future resource transfers, a liquidity problem cannot exist: either th e country is able

to pay, or, if it is not, the problem is exclusively one of insolvency an d can only be

dealt w ith by forgiving the fraction of debt exceeding its ability to pay.

C onsider now h ow uncertainty about the country's value of future stream of earnings,

and thus its future repaym ent capacity, changes the analysis. U ncertainty is

introduced by assum ing repaym ent capacity to be stochastically determ ined by a

num ber of factors, som e of w hich are exogenous to the borrow er (i.e. any exogenous

shock affecting the country's repaym ent capacity, such as a d ro p in the w orld prices

of a country's key export com modities), and others th at are endogenously

determ ined by the country itself (e.g. its investm ent decisions an d adjustm ent efforts).

A dding uncertainty, period-tw o earnings becom e a stochastic variable, w hich for the

sake of sim plicity is assum ed to take only tw o possible realisations of a random

process: one associated w ith a 'g o o d state' of nature, denoted x g and occurring w ith

probability p , and the other w ith a 'b ad state', x b . The tim e flow of e x p e c t e d

repaym ents and new disbursem ents changes accordingly:

Do; r Period 1 P eriod 2

R epaym ent capacity (earnings) XI p X G + ( l - p ) X B

N ew lending Do-xi 0

As a result, the expected value of repaym ent consistent w ith the solvency condition is

now:

(l+r)(D-xi)<pxG+(l-p)xB => (D-xi )<(pxc+( 1 -p)xn)/( 1+r) (13)

In contrast to the condition of certainty considered above, here the question as to

w hether or n o t the debtor is solvent is not well defined. Certainly, w ith (13) holding

true, and pro vided th at lenders are risk-neutral, the country w ill be able to attract

vo luntary lending of the am ount (D-xi). H ow ever, even then it is n ot to be taken for

granted that the country will actually earn enough to repay its debt, d epending

obviously on the realisation of either state of nature. Therefore, it is u p to creditors'

subjective assessm ent of a country's solvency - i.e. condition (13) - to determ ine

w hether the country w ill experience a liquidity crisis. W hat if the inequality

condition (13) is not fulfilled? A t first sight, it w ould app ear th at creditors w ould not

extend further loans (D-xi) to the country, since the expected value of new funds

w ould fall short of the am ount lent (i.e. their face value). If so, a liquidity crisis w ould

occur in period one, and creditors w o u ld be able to collect only a fraction Z, in

p resent value term s, of o utstanding debt. A ssum ing th at Z<(pxG+(l-p)xB)/(l+r) 19,

creditors can, how ever, im prove on their outcom e by rolling over the debt, and

holding o u t until period two. This is so because partial default is possible, b u t not

certain. If the good state is realised, the creditors m ay be paid back in full after all. If

the bad state occurs, they will still have im proved u p o n the outcom e associated w ith

a period-one liquidity crisis, as long as they are able to extract from the country an

interest rate (i) hig h enough to enable creditors to receive all potential resource

transfers in either state. This interest rate is m axim ised by the lenders setting it so as

to exhaust the resource transfer in the good state: (D-xi)(l+i)=XG.20Accordingly, the

scenarios w ould involve:

Do; r Period 1 Period 2

Liquidity crisis (no re­ XT. Z < ( p X G + ( l - p ) X B )

lending)

N ew lending Do-xi x g full paym ent (Do-xi)(l+i)

x b partial default, b u t maxt ( p X G + ( l - p ) x B )

19 Assum ing costs of default arising, for instance, from an imperfect enforcement mechanism, such as the inability to seize all available assets of the debtor, or sim ply from a variety of transaction costs associated with default.

20 That is, with i>r if x d ( l + i ) > D - x i, and r>i if x d ( l + i ) < D-xi. Creditors, however, will always perceive new lending always as concessional, since it exceeds expected value of repayment. N ote also that if there is som e probability of the good state occuring, new lending will always be at i>r.

K rugm an (1988a) em phasises that only existing lenders have the incentive to extend

new borrow ing. By doing so, they m axim ise the potential resource transfer on total

ou tstanding debt, so to say 'd efen d in g ' its net present value. By contrast, new lenders

w ould n ot offer any loans, since the expected value of new len ding falls short of its

face value:

(pxG+(l-p)xB)/(l+r) < (D-xi)(l+i) = x g (14)

V iew ed in isolation, new loans to the country are low er than expected repaym ent,

w hich obviously deters new lenders from entering a contract w ith th a t country,21

W ith this sim ple b u t insightful analysis, K rugm an (1988a) w as am ong the first to

highlight tw o crucial characteristics involving sovereign deb t strategy. First, it

dem onstrates th at the analytical dichotom y of insolvency versus illiquidity is

essentially flawed: if it could be know n w ith certainty that a country is solvent,

lenders w ould extend n ew loans in all cases, so as to ensure full repaym ent of

outstanding loans. In contrast, a country know n to be insolvent w ould consequently

also be illiquid, w hile the opposite w ould not be true. A sim ilar logic applies w hen

future p aym ent capacity is uncertain: as long as creditors deem the expected value of

resource transfers higher than o utstand in g debt, new lending w ill still take place.

W ith uncertainty, how ever, it is creditors' subjective expectations th at can bring

about a liquidity crisis of a solvent borrow er. Illiquidity occurs ou t of expected

insolvency, w h eth er or not expectations prove to be w rong ex post. Second,

K rugm an's analysis explains the typical p attern of 'defensive lending', characterising

the lenders' attitude tow ard highly indebted borrow ers, particularly LICs. In

particular, defensive lending is show n to occur even in a situation of expected

insolvency, since existing creditors have the incentive to defend their existing loans

by m axim ising potential returns (or m inim ising expected losses) on their overall

stake in the debtor country.

21 There are many alternative w ays to show the rationale for new lending by existing creditors. Suppose,