A Quantitative Model of Sovereign Debt, Bailouts and Conditionality

International Financial Institutions provide temporary balance-of-payment support contingent on the implementation of specific macroeconomic policies. While several emerging markets repeatedly used conditional assistance, sovereign defaults occurred. This paper develops a dynamic stochastic model of a small open economy with endogenous default risk and endogenous participation rates in bailout programs. Conditionality enters as a constraint on fiscal policy. In a quantitative application to Argentina the model mimics the empirical duration and frequency of bailout programs. In equilibrium, conditional bailouts generate high and volatile interest spreads. A Laffer-curve in conditionality reflects the trade-off between fostering fiscal reform and creating incentives for non-compliance.