Non-Defaultable Debt and Sovereign Risk

IMF Working Papers, October 28, 2014

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Introducing non-defaultable debt as a limited additional financing option reduces sovereign spreads and raises welfare in the model of equilibrium sovereign risk.
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.
- The introduction 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 non-defaultable 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.
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 are discussed in the context of proposals to introduce common euro-area sovereign bonds that could be virtually non-defaultable.

Initial defaultable sovereign debt level: 66 percent of trend aggregate income.
Initial sovereign spread: 2.9 percent.
Cap on non-defaultable debt considered: up to 10 percent of aggregate income.
Immediate post-introduction spread: 1.4 percent.
Welfare gain: permanent consumption increase of 0.9 percent.
Additional spread reduction if non-defaultable debt is used to buy back previously issued defaultable debt: 0.1 percentage points.
Additional spread reduction if non-defaultable debt finances a “voluntary” debt exchange for previously issued defaultable debt: 0.2 percentage points.

Limited issuance of non-defaultable debt can materially lower sovereign borrowing costs and increase welfare, but effects depend on constraints governing future defaultable debt issuance.
Using non-defaultable debt to retire existing defaultable liabilities produces only marginal additional spread gains (0.1 or 0.2 percentage points).
If defaultable debt issuance remains unrestricted after introducing non-defaultable debt, the initial spread benefits dissipate quickly.
Permitting governments currently in default to increase non-defaultable debt is counterproductive at the time of introduction and yields no meaningful medium-term benefit.

The analysis sheds light on aspects of common euro-area sovereign bond proposals described as virtually non-defaultable.

Source: Juan Carlos Hatchondo, Leonardo Martinez, and Yasin Kursat Onder. "Non-Defaultable Debt and Sovereign Risk", October 28, 2014.