DP647 | The Adjustment Towards National Solvency in Developing Countries: An Application to India

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We use a small macro model of the Indian economy to examine the cost of the adjustment required to secure national solvency. This is compared with the corresponding cost if India were to repudiate its debts and experience financial autarky as a consequence. Our empirical results suggest that a small drop in the trend growth rate, resulting from a loss of foreign investment and lending to the domestic sector, is sufficient to deter reneging, but only if the government is sufficiently far-sighted and chooses a discount rate of 5% (or less) a year. If the Indian government were to discount at a rate of 10% per annum, the drop in trend growth of as much as 4% is insufficient to deter reneging. Debt relief generally improves the relative attractiveness of debt repayment. With a 10% discount rate, however, even writing off 75% of India's external debt fails to make debt repayment incentive-compatible.