Speaker: Cesar Sosa Padilla Araujo is an Assistant Professor in the Economics Department at McMaster University. More »

Abstract: We measure the effects of debt dilution on sovereign default risk and study debt covenants that could mitigate these effects. First, we calibrate a baseline model with endogenous debt duration and default risk (in which debt can be diluted) using data from Spain. Secondly, we present a model in which sovereign bonds contain a covenant that eliminates debt dilution. We quantify the effects of dilution by comparing the simulations of the model with and without this covenant. We  find that dilution accounts for 78 percent of the default risk in the baseline economy. Without dilution, the optimal duration of sovereign debt increases by almost two years. Consumption volatility also increases, but eliminating dilution still produces welfare gains. Introducing debt covenants that could be easier to implement in practice has similar effects. A covenant that penalizes the government for borrowing at bond prices below a threshold is more effective in reducing the default frequency. A covenant that penalizes the government for choosing debt levels above a threshold is more effective in reducing consumption volatility. These covenants could help enforcing  fiscal rules.

Paper: Debt Dilution and Sovereign Default Risk

Last Updated: May 29, 2015