Debt dilution: the problem and possible solutions

The implementation of alternative government debt contracts may help governments deal with the problems of debt dilution, the reduction in the value of existing debt triggered by the issuance of new debt.

Citation

Hatchondo, Juan Carlos, Martinez, Leonardo, and Sosa-Padilla, Cesar. "Debt Dilution and Sovereign Default Risk", Journal of Political Economy (Forthcoming).

 

What is this research about?

Countries often borrow money for projects by issuing bonds to investors who must be repaid the value of the original loan within a certain period of time. Frequently, countries with existing debt continue to borrow money for their projects. This borrowing increases the likelihood of debt default, the risk that the governments cannot pay back their loans, and decreases the value of existing debt (debt dilution) because government bonds are worth less. The existing sovereign debt contracts involving do not address the risk of debt dilution. The purpose of this research is to understand:

  • The importance of debt dilution for governments' default risk.
  • How important is debt dilution for the choice of optimal sovereign debt maturity: whether a country should borrow more short- or long-term.
  • How the negative effects of debt dilution can be lessened through alternative government debt contracts.

What did the researchers do?

The researchers created a baseline mathematical model that captured the interaction between foreign lenders and a small sovereign nation that borrows money. They also tested the usefulness of their model by calibrating it to match economic data from Spain, a country whose economy is facing default risk. The researchers then measured the effects of dilution by comparing simulations of the baseline model with and without dilution. Finally, they explored the effects of different debt contracts (covenants) on debt dilution.

What did the researchers find?

The researchers found that:

  • Debt dilution accounts for 78% of the default risk. In other words, if a country eliminates debt dilution, the number of defaults per 100 years decreases from 2.8 to 0.6.
  • Without dilution, the government should choose to lengthen the maturity of its debt portfolio.  The benefits of this strategy are greater than the cost.
  • Although implementing a debt contract that completely eliminates dilution is too difficult, gains from eliminating dilution could be obtained from simpler debt contracts that are easier to implement, such as:

○        A price-threshold covenant, which compensates bondholders when the bond price at which the government borrows is below a threshold, effectively reduces the risk of default.
○        A debt-threshold covenant, which compensates bondholders when the level of debt is above a threshold, effectively increases consumption stability.

How can you use this research?

This research supports the inclusion of debt dilution in discussions of international financial architecture and debt management by different countries. The findings can help countries develop more appropriate policies to deal with over-borrowing.

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