Sovereign-Debt Crises and Floating-Rate Bonds
The choice of sovereign-debt maturity in countries at risk of default represents a complex set of competing forces. The tradeoffs reflect the underlying frictions present in international sovereign-debt markets. The primary frictions are the lack of state contingency in debt contracts and the inability of the government to commit to future actions. These generate two forces in terms of maturity choice. The first is that long-term bonds may be a useful tool for a government to hedge shocks to the cost of funds, say arising from business cycle fluctuations. However, the lack of contingency opens the door to default occurring in equilibrium. Because of the government’s inability to commit to future fiscal decisions, bondholders are subject to future dilution of their claims. This generates an opposite force: short-term bonds provide protection from future dilution and, as we shall see, provide better incentives to the government to minimize the costs of default.
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