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Sovereign debt maturity structure and its costs

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Abstract

I propose a theoretical model of a debt contract between a sovereign and its international lenders that determines the optimal debt maturity structure and related costs. It is shaped by two financial frictions: limited liability (the country cannot guarantee that it will not dilute its obligations or default on them) and market incompleteness. In equilibrium, debt dilution constrains the amount of long-term debt issuance. I use this framework to evaluate the impact of two policy interventions: the possibility of sovereign debt restructuring with private creditors and international official lending in the event of exclusion from the international capital markets. The possibility of restructuring after default stimulates long-term debt issuance; however, in equilibrium, those tools are unable to loosen the constraint on long-term debt issuance. Consistently with the empirical literature, I find that even when these policy options are available, the country tends to issue mainly short-term debt.

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Notes

  1. I define debt dilution following Hatchondo et al. (2016): “Debt dilution refers to the reduction in the value of existing debt triggered by the issuance of new debt. Issuing new debt reduces the value of existing debt because it increases the probability of default.”

  2. For a presentation and discussion of SDRM and Redemption Funds see Cioffi et al. (2019), and Committeri and Tommasino (2018).

  3. Long-term debt and its cost have no time index since this type of debt can be issued only at time zero and repaid in the last period, \(t = 2\).

  4. The two quantities the country has to repay or receives in the interim period do not need to be the same in absolute value. They are set equal but with opposite sign for simplicity and in order to reduce the number of parameters.

  5. See Alfaro and Kanczuk (2005) for a discussion on output losses in the event of default.

  6. In case of partial default the deadweight loss is lower than in the case of full default; therefore, the overall welfare improvement for the system given by the possibility of partial default is imposed by construction and justified by the empirical evidence mentioned in the introduction.

  7. See for details https://www.imf.org/en/News/Articles/2015/09/14/01/49/pr1631.

  8. If the country repays also its short-term obligations with delay, the case would become analogous to the reprofiling case of the next section.

  9. The repayment of short-term obligations in case of full default would not change the equivalence result.

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Acknowledgements

I would like to thank Mark Aguiar, Kartik Anand, Tamon Asonuma, Giancarlo Corsetti, Riccardo Cristadoro, Aitor Erce, Christian Keuschnigg, Igor Livshits, Enrico Mallucci, Hélène Rey, Pietro Rizza and two anonymous referees for very helpful comments. Part of this paper was written, while the author was visiting the London Business School, whose hospitality is gratefully acknowledged.

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    Flavia Corneli

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Corneli, F. Sovereign debt maturity structure and its costs. Int Tax Public Finance 31, 262–297 (2024). https://doi.org/10.1007/s10797-023-09800-1

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