Willingness to pay and the sovereign debt contract

This paper uses a contract theory model to argue that covenants ruling debt renegotiations are important to assure the sovereign willingness to pay. The model includes the following features: first, collective action clauses, exit consents, aggregation provisions and pari passu clauses play an important role in the post default "game" of negotiations and coalitions. These covenants are represented in reduced form by the endogenous probability of refinancing a defaulted sovereign debt. Second, the model has "endogenous bad luck" because the unfavorable state of nature where default occurs depends on the level of indebtedness, which is itself an endogenous variable. Third, "vultures", contrary to conventional wisdom, tend to improve the access of emerging economies to capital markets because they might help to rule out strategic defaults. And fourth, under special assumptions the model is able to analyze the possibility of post default discrimination between domestic and foreign bondholders.