The Economics and Law of Sovereign Debt and Default

Abstract

This paper surveys the recent literature on sovereign debt and relates it to the evolution of the legal principles underlying the sovereign debt market and the experience of the most recent debt crises and defaults. It finds limited support for theories that explain the feasibility of sovereign debt based on either external sanctions or exclusion from the international capital market and more support for explanations that emphasize domestic costs of default. The paper concludes that there remains a case for establishing institutions that reduce the cost of default but the design of such institutions is not a trivial task.

Sovereign defaults and liquidity crises

“…See Grossman and Van Huyck (1988), Bulow and Rogoff (1989), Fernandez and Rosenthal (1990), Cole and Kehoe (1998), Kletzer and Wright (2000), Wright (2002), Amador (2004), Yue (2005), Aguiar and Gopinath (2006) and Arellano (2008), among others. Eaton and Fernandez (1995), Sturzenegger and Zettelmeyer (2006) and Panizza et al (2009) survey this literature.…”

The role of sovereign credit ratings in fiscal discipline

“…The counter-cyclicality of sovereign borrowing suggested by these models is not supported by empirical evidence however (Yeyati, 2009;Gavin and Perotti, 1997). The anecdotal evidence suggests that the pro-cyclicality of borrowing is mainly driven by sovereign authorities' tendency to borrow whenever conditions allow (Panizza et al, 2009). Two constraints emerge limiting the tendency to borrow.…”

“…According to most of the models surveyed in Panizza et al (2009), countries issue debt in order to transfer income from bad times to good times for consumption smoothing purposes. The counter-cyclicality of sovereign borrowing suggested by these models is not supported by empirical evidence however (Yeyati, 2009;Gavin and Perotti, 1997).…”

6. Count the Limbs: Designing Robust Aggregation Clauses in Sovereign Bonds

“…With the right incentives, most of the bondholders were likely to choose new, performing bonds over the prospect of default and years spent fighting to overcome sovereign immunity and scouring the world for attachable government assets. Within a decade of the first Brady bond deal, techniques such as exit consents and minimum participation thresholds paved the way for a string of relatively speedy debt exchanges, which delivered substantial debt relief (Panizza et al 2009, Bi et al 2009 As bond exchanges gathered momentum, more and more market participants argued that the official sector's war on unanimity in New York was misguided. Bond restructuring took less time than haggling with banks in creditor committees and dealing with their regulatory accounting constraints.…”