## Non-Defaultable Debt and Sovereign Risk

_IMF Working Papers, October 28, 2014_

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## Bibliographic details
- Authors: Juan Carlos Hatchondo, Leonardo Martinez, Yasin Kursat Onder
- Published: October 28, 2014
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781498325189.001

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### Summary findings
- 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.

### Quantitative results and key statistics
- 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.

### Policy implications and scenarios analyzed
- 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.

### Additional notes
- 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.*

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/non-defaultable-debt-and-sovereign-risk-42421_