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Conditionality covenants: Commitment versus discretion in sovereign credit contracts

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  • Sherif Khalifa

    (California State University, Fullerton, USA)

Abstract

This paper investigates the impact of imposing conditionality covenants on the performance of the signatories to a sovereign credit contract. A two period model is developed in which creditors provide a loan to a sovereign conditional upon the implementation of investments. Commitment to these covenants overcome the debt repudiation problem, as it increases the likelihood of repayment, if the implemented conditionalities contribute to an increase in the sovereign's productive capacity. A three period model is also developed to entertain the possibility that the sovereign engage in credit activities in subsequent periods, where in the final period the debtor has obligations towards junior and senior creditors. This allows for dynamic inconsistency, as the sovereign may be tempted to increase its debt in the second period, thus increasing the probability of repudiation in the third period. Imposing conditionality covenants by senior creditors that increase the portion they can appropriate in case of repudiation, relative to junior creditors, reduces the supply of credit by junior creditors in the second period and thus overcomes the debt dilution problem. Copyright © 2009 John Wiley & Sons, Ltd.

Suggested Citation

  • Sherif Khalifa, 2010. "Conditionality covenants: Commitment versus discretion in sovereign credit contracts," Journal of International Development, John Wiley & Sons, Ltd., vol. 22(4), pages 411-423.
  • Handle: RePEc:wly:jintdv:v:22:y:2010:i:4:p:411-423
    DOI: 10.1002/jid.1576
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    References listed on IDEAS

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    1. Wolfgang Mayer & Alex Mourmouras, 2005. "On the Viability of Conditional Assistance Programs," IMF Working Papers 05/121, International Monetary Fund.
    2. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-178, February.
    3. Bolton, Patrick & Jeanne, Olivier, 2005. "Structuring and Restructuring Sovereign Debt: The Role of Seniority," CEPR Discussion Papers 4901, C.E.P.R. Discussion Papers.
    4. Alex Mourmouras & Peter Rangazas, 2004. "Conditional Lending Under Altruism," IMF Working Papers 04/100, International Monetary Fund.
    5. Douglas Gale & Martin Hellwig, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Oxford University Press, vol. 52(4), pages 647-663.
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