IMF lending in sovereign default

This paper proposes that an International Monetary Fund (IMF) policy shift was the reason behind major changes in sovereign debt negotiation outcomes observed in 1989. The new policy, in marked departure from past policy, allowed the IMF to lend to nations in default. The paper highlights the stark improvements in debt forgiveness and post-negotiation debt servicing ability coincident with the IMF policy shift. A theoretical framework is proposed in which the IMF policy shift causes the observed changes in negotiation outcomes. The model highlights the policy’s potential to improve a country’s outside option during negotiations of defaulted debt. In the model, this improvement leads to increased debt forgiveness which in turn leads to less post-negotiation debt servicing difficulties. The model is then used to address an important question regarding the nature of post-negotiation default risk. The case is made that countries face persistent, rather than temporary, default risk after such negotiations. To avert such risk, they moderate their borrowing.