Sayantan Ghosal and Kannika Thampanishvong

CSGR Working Paper No. 159/05

We study the interaction between (a) inefficiencies in the post-default debtor-creditor bargaining game and (b) ex ante debtor moral hazard and excessive lending in sovereign debt markets. Conditional on default, selffulfilling debt crisis driven by creditor coordination failure exists and crisis risk is inefficiently high. Strengthening collective action clauses (CACs) has an ambiguous impact on crisis risk. Even with ex ante debtor moral hazard, crisis risk remains inefficiently high. Moreover, even without debtor moral hazard, excessive lending by creditors generates, endogenously, positive default probability. We establish the case for a formal sovereign bankruptcy procedure to complement the role of CACs.

Keywords: Sovereign Debt, Bargaining, Coordination, Moral Hazard, Collective Action Clauses.