Sovereign Debt and Moral Hazard: The Role of Collective Action and Contractual Ambiguity

If Boilerplate Could Talk: The Work of Standard Terms in Sovereign Bond Contracts

“…Sovereign borrowers hesitate to adopt terms that make their debt contracts more restructuring-friendly, even when these initiatives are backed by a broad consensus among policymakers, international organizations, and academics. A leading hypothesis in economics and law explains borrower hesitation as a rational—and quite possibly efficient—response to moral hazard created by the lack of hard enforcement of sovereign debt contracts (Dooley 2000; Shleifer 2003; Bratton 2006; Bolton and Jeanne 2009; Kahan and Leshem 2017). By designing contracts that make debt restructuring costly, debtors show commitment to repay, and are rewarded with better financial terms.…”

“…The first maintains that change is undesirable in light of limited contract enforcement, a fact of life in sovereign debt (Eaton and Gersovitz 1981). Rigid modification and strict enforcement terms respond to creditors’ worries about inability or unwillingness to pay: by making default more painful for the debtor, they function as a commitment device (Bratton 2006; Bolton and Jeanne 2009; Kahan and Leshem 2017). The second explanation points to the “stickiness” of contract terms (Financial Markets Law Committee 2005; Gulati and Scott 2013).…”

“…Debt managers and investors also rejected the view that non-financial contract terms could reduce borrowing costs or attract more investors at the margin by reducing debtor moral hazard or signaling the debtor’s ability and willingness to pay (cf. Shleifer 2003; Kahan and Leshem 2017; Demiroglu and James 2010). In line with socio-legal theories, debt managers used standard terms to communicate membership in a cohort of sovereign borrowers, and were reluctant to adopt new terms for fear of inadvertently associating with a lower-status cohort.…”

“…13.Debt managers’ explanations used the language of learning, and also had a Coasean quality, inasmuch as they sought to minimize uncertainty about contract rights inherent in adopting untested boilerplate. Kahan and Leshem (2017) interpret uncertainty in the old formulation as a deliberate commitment device. While we do not rule out the possibility, we note that debt manager and investor explanations for adopting new clauses, as well as the observed market-wide shifts, cut in the opposite direction.…”

Quantitative models of sovereign risk and state-contingent debt

“…In insurance terminology, moral hazard is defined to occur in the "case when people engage in riskier behavior with insurance than they would if they did not have insurance" (Openstax, Chapter 16, 2020) 179 , which in turn increases the probability that insurance is activated and augments expected costs for the insurer. Moral hazard has stood at the heart of public policy debates on sovereign debt restructuring and has given rise to an extensive literature on creditor and debtor moral hazard and institutional solutions that serve to reveal hidden interests or align incentives (Kahan and Leshem, 2017;Ghosal and Miller, 2003). In the context of GDP-linked bonds, given the potential of making lower debt repayments in times of lower economic growth, the sovereign may be partially incentivized to steer away from growth-enhancing reforms and policies (Fournier and Lehr, 2018;IMF, 2017;Bowman and Naylor, 2016;Chamon and Mauro, 2005;Schroder et al,2004).…”