Sovereign Debt and Moral Hazard: The Role of Collective Action and Contractual Uncertainty

Sovereign Debt and Moral Hazard: The Role of Collective Action and Contractual Uncertainty

Marcel Kahan, Shmuel Leshem

Series number :

Serial Number: 
620/2021

Date posted :

December 19 2021

Last revised :

December 19 2021
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Keywords

  • Sovereign debt • 
  • pari passu clauses • 
  • collective action • 
  • strategic bargaining

The ambiguous phrasing of pari passu (equal treatment) clauses in sovereign debt contracts has long baffled commentators. We show that in the presence of asymmetric information on a sovereign borrower’s ability to pay, an uncertain clause gives rise to a collective action problem among creditors that can reduce sovereign moral hazard.

By varying the clause, parties can calibrate a sovereign’s expected default costs and payments to creditors and thereby optimally trade off the sovereign’s moral hazard and (deadweight) default costs. As information asymmetry decreases, a pari passu clause becomes a coarser instrument for configuring creditors’ incentives and mitigating moral hazard.

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Authors

Real name:
Shmuel Leshem