A Dynamic Theory of Debt Restructuring

Abstract

This paper studies a strategic role of debt restructuring under an optimal debt contract. It explores an infinite-horizon costly-monitoring model under Markov income shocks. It shows that, if (1) a borrower's project is expected to be profitable, (2) a lender's outside options are positively correlated with the borrower's project, and (3) disclosure costs are a medium level, then restructuring is preferred to termination of contract in default under an optimal contract. This optimal contract is implementable in a debt contract that permits debt restructuring. This paper also provides insights into autarkic financing features of the world's poorest economies.