Debt, Power, and Play: Modeling Sovereign Restructuring with Creditors and the IMF

Abstract

This paper develops a continuous-time stochastic model of sovereign debt sustainability with endogenous restructuring and an active multilateral lender. The sovereign interacts with two heterogeneous creditor classes and the IMF within a dynamic stochastic game featuring jump–diffusion uncertainty. Fiscal income, debt accumulation, and interest rates evolve as correlated diffusion processes, while restructuring events occur with state-dependent Poisson intensity. Haircuts are determined endogenously through a Nash bargaining mechanism conditional on the pre-default state, rather than being imposed exogenously. The IMF is modeled as a forward-looking strategic actor that solves its own Hamilton–Jacobi–Bellman (HJB) problem, optimally selecting disbursements subject to program and sustainability constraints. The resulting three-agent equilibrium jointly determines sovereign fiscal policy, creditor recovery values, and IMF lending behavior. The model fully characterizes sustainability thresholds, restructuring triggers, and the stabilizing—or potentially distortionary—effects of international financial assistance. In the extended Version B, the sovereign’s default threshold incorporates an IMF-linked liquidity offset, endogenizing bailout effects within the Nash bargaining structure. This formulation allows the framework to capture both the liquidity-support and moral-hazard channels of IMF lending. The model is analytically tractable, fully stochastic, and suitable for stress testing sovereign solvency under correlated macro-financial risks, offering a versatile platform for exploring conditionality, reform effort, and crisis mitigation dynamics.