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The idea that under limited enforcement it may be desirable to create a debt structure that is difficult to renegotiate is, of course, a familiar theme in corporate finance. See, for example Hart and Moore (1995), Dewatripont and Maskin (1995), Bolton and Scharfstein (1996), Diamond and Rajan (2001) and Diamond (2004).
Collective action clauses facilitate bond restructurings by lowering the threshold for agreement to a restructuring by bondholders from unanimity to a 75 percent super-majority rule.
Michael Peterson, “A crash course in default,” Euromoney (October 1999), pp. 47-50.
Debt restructuring was difficult but not impossible, thanks to a creative use of exit consent clauses (Buchheit and Gulati, 2000), leading Roubini and Setser (2004) to conclude that the lack of creditor coordination was overstated as an impediment to debt restructuring. However, the expectation that bonded debt would be difficult to restructure seems to have played a significant role in shaping the equilibrium structure of sovereign debt in the 1990s.
See Bolton and Jeanne (2005) for a more general model where g is optimally determined by the sovereign.
It is generally assumed in the literature that the cost of defaulting is the same whether the sovereign defaults in full or whether it repays part of its debt. This is a somewhat extreme assumption. One might want to consider the more general default cost function γ(s)y, where γ(s) is increasing in the repayment shortfall s from zero to a maximum value,
Another approach views the cost of default as a loss of reputation (e.g., Eaton and Gersowitz, 1981). See Bolton and Jeanne (2005) for a model of sovereign debt restructuring that includes both types of cost.
The inability to renegotiate the debt ex-post may be to the detriment of bondholders’ collective interests. Even so, because of a free-rider problem—as in Diamond and Rajan (2001) or Jeanne (2004)—widely dispersed debts will not be renegotiable ex-post. For example, individual litigating creditors could hope to seize some collateral, but if they litigate in an uncoordinated way, these creditors might impose an output cost on the country that is much larger than the value of collateral that they can seize collectively. Similarly, the bondholders may be unable to accept a voluntary decentralized debt exchange or repurchase, even an efficient one, because of free-riding by holdouts (Bulow and Rogoff, 1991).
This result is due to our assumption that output realizations can be arbitrarily small. If the distribution of output had a strictly positive lower bound
Differentiating (2) shows that V is strictly increasing with Dr if
We assume that this is possible because
Closed-form solutions for the equilibrium can be derived in the case of a uniform distribution. The details are available upon request to the authors.
The sovereign is rationed only if it was able to borrow with n-debt and not with r-debt under laissez-faire, that is if ω ≥ 1/2 and ω ≤ ω*.