Sovereign debt crises are associated with severe output and consumption losses for the debtor country and with reductions in payments for the creditors. Moreover, such crises are accompanied by trade disruptions that lead to a sharp fall in the imports of intermediate inputs. Here I study the efficient risk-sharing arrangement between a sovereign borrower and foreign lenders in a production economy where the sovereign government cannot commit and has some private information. I show that the ex-ante efficient arrangement involves outcomes that resemble sovereign default episodes in the data. These outcomes are ex-post inefficient, in the sense that if the borrower and the lenders could renegotiate the terms of their agreement, committing not to do it again in the future, then both could be made better off. The resulting efficient allocations can be implemented with non-contingent defaultable bonds and active maturity management. Defaults and periods of temporary exclusion from international credit markets happen along the equilibrium path and are essential to supporting the efficient allocation. Furthermore, as in the data, interest rate spreads increase and the maturity composition of debt shifts toward short-term debt as the indebtedness of the sovereign borrower increases.

Credit market frictions are perceived to be a barrier to reallocation. The recent trade literature has emphasized that factor reallocation across firms is important for the gains for trade to be realized. Motivated by these observations, we investigate whether or not credit frictions reduce the gains from a trade liberalization. We consider a dynamic general equilibrium trade model with two alternative specifications of credit market frictions: limited enforcement, as in Albuquerque and Hopenhayn (2004), and collateral constraints, as in Evans and Jovanovic (1989). We show that with limited enforcement there are the same percentage gains from trade liberalization as with perfect credit markets. This is because the debt limits that firms face respond to profit opportunities; exporters expand and non-exporters shrink efficiently. Under the collateral constraints specification, debt limits do not respond. Therefore, reallocation is reduced and gains are lower. Using data from a trade liberalization in Colombia, we find that firm-level changes in capital usage and entry decisions in the export market after the reform are consistent with the limited enforcement specification.

Should a benevolent government impose capital controls? I study the best equilibrium outcome of a Ramsey taxation model for a small open economy. If the government can commit, capital controls are detrimental. In contrast, I show that when the government lacks commitment, capital controls on inflows are necessary to support the efficient allocation when the economy is capital scarce. The optimal policy calls for a lower capital income tax for domestic agents than for foreigners. This is because inducing domestic agents to increase saving helps to relax the future commitment problem for the government. When the international interest rate is equal to the time discount factor of domestic residents, then capital controls are only temporary and the economy converges to a steady state with no capital income taxes. The welfare benefits of optimal capital controls are larger for countries with higher expected growth. These results extend to the two country general equilibrium case.