The Economic Logic blog by guest posters

Monday, January 20, 2014

A solution to sovereign debt dilution

Contributed by H. Economicus

When a country like Greece gets close to a situation where it cannot pay interest on some of its debt, it sometimes gets a new loan to stay liquid. Current bondholder may rejoice about the interest payout, but they may worry about the increased likelihood of a haircut on their bonds, as the difficulties of Greece have only compounded. Imagine the same scenario with the roll-over of some matured bonds. Because of the increased risk and interest rate, Greece needs to borrow a lot just to roll over. This satisfies the lucky bondholder who just got their money, but this dilutes the bonds of the other bond holders. And if a haircut needs to apply to Greek debt, it is applies uniformly across all maturities, while clearly the risk different maturities were facing were clearly different. A political decision, whether to apply a haircut or go for another loan, has thus important and redistributive consequences for bond holders. One can do better.

Satyajit Chatterjee and Burcu Eyigungor propose that sovereign debt should be subject to explicit seniority rules. One could imagine one that gives more seniority to older maturities, which would mean that the value of a bond increases with time as risk dissipates through successive roll-over rounds. This reduces the risk of dilution and of default, as now the sovereign has to take into account the high cost of raising funds with low seniority. For the case of Argentina, Chatterjee and Eyigungor show that this reduces the risk of default by a whooping 40%, reduces the interest spread by 42% and only slightly increases debt. But for this to work efficiently, it requires that settlement is immediate and costless, which is unfortunately unlikely for sovereign deb where political haggling is the norm.

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