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Debt Dilution and Sovereign Default Risk

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  • Juan Carlos Hatchondo
  • Leonardo Martinez
  • César Sosa-Padilla

Abstract

We measure the effects of debt dilution on sovereign default risk and study debt covenants that could mitigate these effects. We calibrate a baseline model with endogenous debt duration and default risk (in which debt can be diluted) using data from Spain. We find that debt dilution accounts for 78 percent of the default risk in the baseline economy and that eliminating dilution increases the optimal duration of sovereign debt by almost 2 years. Eliminating dilution also increases consumption volatility but still produces welfare gains. The debt covenants we study could help enforcing fiscal rules.

Suggested Citation

  • Juan Carlos Hatchondo & Leonardo Martinez & César Sosa-Padilla, 2016. "Debt Dilution and Sovereign Default Risk," Journal of Political Economy, University of Chicago Press, vol. 124(5), pages 1383-1422.
  • Handle: RePEc:ucp:jpolec:doi:10.1086/688081
    DOI: 10.1086/688081
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    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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