The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
Juan Carlos Hatchondo, Leonardo Martinez, and Yasin Kursat Onder
INTERNATIONAL MONETARY FUND
We quantify gains from introducing non-defaultable debt as a limited additional financing option into a model of equilibrium sovereign risk. We find that, 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, and 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 nondefaultable 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. We also show that 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 shed light on different aspects of proposals to introduce common euro-area sovereign bonds that could be virtually non-defaultable.