Debt Seniority and Sovereign Debt Crises

By Anil Ari, Giancarlo Corsetti, Luca Dedola

May 9, 2018

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Anil Ari, Giancarlo Corsetti, and Luca Dedola. Debt Seniority and Sovereign Debt Crises, (USA: International Monetary Fund, 2018) accessed November 21, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

Is the seniority structure of sovereign debt neutral for a government's decision between defaulting and raising surpluses? In this paper, we address this question using a model of debt crises where a discretionary government endogenously chooses distortionary taxation and whether to apply an optimal haircut to bondholders. We show that when the size of senior tranches is small, a version of the Modigliani-Miller theorem holds: tranching just redistributes government revenues from junior to senior bondholders, while taxes and government borrowing costs remain unchanged. However, as senior tranches become sufficiently large, default costs on senior debt transpire into a stronger commitment to repay not only the senior tranche, but also the junior one. We show that there is a lower threshold for senior bonds above which tranching can eliminate default on both junior and senior debt, and an upper threshold beyond which the government defaults also on senior debt.

Subject: Bonds, Debt default, Financial crises, Public debt, Revenue administration

Keywords: Senior debt, WP

Publication Details

Pages:

43
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2018/104
Stock No:

WPIEA2018104
ISBN:

9781484353691
ISSN:

1018-5941

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