Political Risk and Sovereign Debt Contracts

Abstract

Default on sovereign debt is a form of political risk. Issuers and creditors have responded to this risk both by strengthening the terms in sovereign debt contracts that enable creditors to enforce their debts judicially and by creating terms that enable sovereigns to restructure their debts. These apparently contradictory approaches reflect attempts to solve an incomplete contracting problem in which debtors need to be forced to repay debts in good states of the world; debtors need to be granted partial relief from debt payments in bad states; debtors may attempt to exploit divisions among creditors in order to opportunistically reduce their debt burden; debtors may engage in excessively risky activities using creditors’ money; and debtors and creditors may attempt to externalize costs on the taxpayers of other countries. We support this argument with an empirical overview of the development of sovereign bond terms from 1960 to the present.