Non-Defaultable Debt and Sovereign Risk

Author/Editor:

Juan Carlos Hatchondo ; Leonardo Martinez ; Yasin Kursat Onder

Publication Date:

October 28, 2014

Electronic Access:

Free Full Text. Use the free Adobe Acrobat Reader to view this PDF file

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

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.

Series:

Working Paper No. 14/198

Subject:

English

Publication Date:

October 28, 2014

ISBN/ISSN:

9781498325189/1018-5941

Stock No:

WPIEA2014198

Price:

$18.00 (Academic Rate:$18.00)

Format:

Paper

Pages:

25

Please address any questions about this title to publications@imf.org