M-RCBG Associate Working Paper No. 185

Political Economy of Sovereign Debt Restructuring: Burden-Sharing, Haircuts, and the Creditor’s Outside Option

Alejandro Jimenez

Winner of the 2022 John Dunlop Undergraduate Thesis Prize



The outcome of a sovereign debt restructuring (SDR) reflects the relative bargaining power between creditors and debtors. I apply the logic of the Rubinstein (1982) bargaining model by assuming that the creditors’ opportunity cost of bargaining, or their outside option, matters for SDR outcomes. I argue that the creditor’s outside option is other financial assets and provide statistical evidence that returns on financial assets significantly predicts how creditors and debtors share the burden in a restructuring. When financial asset returns are high, creditors on average accept smaller net present value (NPV) haircuts, expressed as a percentage point reduction of the original sovereign loans. I also show this result with a simple game matrix, in which the Nash equilibrium depends on creditors weighing the post-restructuring value of the debt against the debt’s sale value multiplied by an exogenous rate of return. Additionally, I test the hypothesis proposed in Asonuma & Joo 2020 that GDP growth strengthens the outside option; GDP growth is an insignificant predictor of haircuts in a joint test with financial asset returns. I conclude that trends in global asset markets determine burden-sharing between debtors and creditors in the repayment of past loans.

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