The paper presents a model to explain why countries sometimes face capital outflows when they suffer an adverse macroeconomic shock. With complete markets and perfect insurance, we wouldn't see such a situation. But in the model, the markets aren't complete. The borrower is a sovereign nation, and hence can repudiate the loan. Moreover, the lender cannot observe whether the borrower invests the loaned funds productively or uses them for consumption. The only way to incentivize the borrower to invest some of the funds in equilibrium is if insurance is incomplete, so that the borrower's future utility has some dependence on their investment choice. Thus, moral hazard imposes an insurance-incentives tradeoff.
While preparing for the presentation, I came across an interesting paper by Drelichman and Voth (2011) called "Lending to the Borrower from Hell: Debt and Default in the Age of Philip II.” Here's the abstract:
What sustained borrowing without third-party enforcement in the early days of sovereign lending? Philip II of Spain accumulated towering debts while stopping all payments to his lenders four times. How could the sovereign borrow much and default often? We argue that bankers’ ability to cut off Philip II’s access to smoothing services was key. A form of syndicated lending created cohesion among his Genoese bankers. As a result, lending moratoria were sustained through a ‘cheat-the-cheater’ mechanism. Our article thus lends empirical support to a recent literature that emphasises the role of bankers’ incentives for continued sovereign borrowing.