Description

We quantify gains from introducing non-defaultable debt as a limited additional financing option into amodel of equilibrium sovereign risk. We find that, for an initial (defaultable) sovereign debt level equalto 66 percent of trend aggregate income and a sovereign spread of 2.9 percent, introducing the possibilityof issuing non-defaultable debt for up to 10 percent of aggregate income reduces immediately the spreadto 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 nondefaultabledebt to buy back (finance a “voluntary” debt exchange for) previously issued defaultabledebt. Without restrictions to defaultable debt issuances in the future, the spread reduction achieved by theintroduction of non-defaultable debt is short lived. We also show that allowing governments in default toincrease non-defaultable debt is damaging at the time non-defaultable debt is introduced andinconsequential in the medium term. These findings shed light on different aspects of proposals tointroduce common euro-area sovereign bonds that could be virtually non-defaultable.

More publications in this series: Working Papers

More publications by: Juan Carlos Hatchondo ; Leonardo Martinez ; Yasin Kursat Onder