Debt Dilution and Sovereign Default Risk

IMF Working Papers, March 1, 2011

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Proposes a modification to a baseline sovereign default framework to quantify the importance of debt dilution for the level and volatility of the interest rate spread paid by sovereigns.
Compares simulations of the baseline model (with debt dilution) to a modified model without dilution.
Calibrates the baseline model to mimic:
- the mean and standard deviation of the spread,
- the external debt level,
- the mean debt duration,
- a measure of default frequency in the data.

Approach: simulate a baseline sovereign default model that includes debt dilution and compare with a modified version that eliminates dilution.
Calibration targets: mean spread, standard deviation of spread, external debt level, mean debt duration, default frequency.

Number of defaults per 100 years:
- with dilution: 3.10
- without dilution: 0.42
Mean spread:
- with dilution: 7.38%
- without dilution: 0.57%
Standard deviation of the spread:
- with dilution: 2.45
- without dilution: 0.72
Reduction in the level of sovereign debt when dilution is eliminated:
- 36% of the face value
- 11% of the market value

Default risk declines partly because eliminating dilution reduces the equilibrium level of sovereign debt (figures above).
The most important effect of debt dilution on default risk arises from a shift in the set of government's borrowing opportunities when dilution is present versus absent.
Results are obtained without assuming commitment to future repayment policies and without contingent sovereign debt.
The analysis is relevant for other credit markets where the debt dilution problem could be present.

Leonardo Martinez, Juan Carlos Hatchondo, Cesar Sosa Padilla, Debt Dilution and Sovereign Default Risk (IMF Working Paper No. 2011/070).