We
investigate the optimum lending arrangements when there is the possibility of
partial default, in addition to full default when physical capital is
unobservable. In a model calibrated on Argentina, we find an optimal debt
reduction of 39%, and optimal re-entry probability of 0.10. Full default is
more likely when total factor productivity is very low, and either debt is low
or very high. Partial default is more likely when debt is moderate. Monte Carlo
simulations under the optimum lending arrangements indicate the economy spends
47.90% of the time in partial default, translating into an average partial
default probability of 9.12%. This is quantitatively close to what emerging
economies have experienced, thus suggesting that current arrangements are close
to optimal. In fact, if there is a competitive market for borrowers, we would
expect risk-neutral lenders to offer schemes giving higher utility to the
borrower, and thus the competitive market should converge to the optimal
scheme.
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