Non-Defaultable Debt and Sovereign Risk
Juan Carlos Hatchondo,
Leonardo Martinez and
No 2014/198, IMF Working Papers from International Monetary Fund
We quantify gains from introducing non-defaultable debt as a limited additional financing option into a model of equilibrium sovereign risk. We find that, for an initial (defaultable) sovereign debt level equal to 66 percent of trend aggregate income and a sovereign spread of 2.9 percent, introducing the possibility of issuing non-defaultable debt for up to 10 percent of aggregate income reduces immediately the spread to 1.4 percent, and implies a welfare gain equivalent to a permanent consumption increase of 0.9 percent. The spread reduction would be only 0.1 (0.2) percentage points higher if the government uses nondefaultable debt to buy back (finance a “voluntary” debt exchange for) previously issued defaultable debt. Without restrictions to defaultable debt issuances in the future, the spread reduction achieved by the introduction of non-defaultable debt is short lived. We also show that allowing governments in default to increase non-defaultable debt is damaging at the time non-defaultable debt is introduced and inconsequential in the medium term. These findings shed light on different aspects of proposals to introduce common euro-area sovereign bonds that could be virtually non-defaultable.
Keywords: WP; debt limit; non-defaultable bond; sovereign default; sovereign debt; Eurobonds; red bonds; blue bonds; buyback; voluntary debt exchange; defaultable debt; debt exchange; bond-price function; defaulted bond; Bonds; Personal income; Sovereign bonds; Debt default; Debt limits; Europe (search for similar items in EconPapers)
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Journal Article: Non-defaultable debt and sovereign risk (2017)
Working Paper: Non-Defaultable Debt and Sovereign Risk (2016)
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