Sudden stops, time inconsistency, and the duration of sovereign debt
IMF Working Papers, July 19, 2013
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Bibliographic details
- Authors: Juan Carlos Hatchondo, Leonardo Martinez
- Published: July 19, 2013
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781475586176.001
Overview
- Study context: sovereign debt duration chosen by the government within a standard model of sovereign default.
- Government trade-off examined:
- Increase duration of debt to mitigate rollover risk.
- Lower duration to mitigate the debt dilution problem.
Main findings
- When the government decides the debt duration on a sequential basis, sudden stop risk increases the average duration by 1 year.
- Time inconsistency result: governments would like to commit to a duration that is 1.7 years shorter than the one they choose when decisions are made sequentially.
Mechanisms and trade-offs
- Rollover risk: longer-duration debt reduces the probability and impact of rollover crises (sudden stops).
- Debt dilution problem: longer maturity increases the dilution of existing debt claims, creating incentives to shorten duration.
- Sequential decision-making amplifies sudden-stop considerations, leading to longer chosen durations relative to a commitment benchmark.
Implications for sovereign debt management
- Sudden-stop risk can bias sequential decision-making toward longer maturities by an exact margin of 1 year.
- Commitment mechanisms that credibly shorten chosen duration by 1.7 years relative to sequential choices could mitigate time inconsistency and reduce debt dilution concerns.
Source: Sudden stops, time inconsistency, and the duration of sovereign debt, Juan Carlos Hatchondo and Leonardo Martinez, July 19, 2013.