Financial Stability Paper No 27: Sovereign Default and State-Contingent Debt

Martin Brooke, Alex Pienkowski, Rhys Mendes () and Eric Santor
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Martin Brooke: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Alex Pienkowski: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Eric Santor: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH

No 27, Bank of England Financial Stability Papers from Bank of England

Abstract: In recent decades, the common perception had been that sovereign debt crises were unlikely to occur in advanced economies. Events in the euro area over the past few years, however, have undermined this view. The sovereign debt restructuring in Greece and the events surrounding the IMF-EU support packages for Ireland, Portugal and Cyprus have exposed fault lines in the existing practices for sovereign debt crisis resolution — perhaps most importantly, an overreliance on official sector liquidity support. This paper argues that the current approach is suboptimal for five main reasons: (i) it increases the risk of moral hazard; (ii) it incentivises short-term lending, which can increase the risk of liquidity crises; (iii) it puts an inequitable amount of tax-payer resources at risk; (iv) substantial official sector holdings of an insolvent sovereign’s debt can complicate negotiated debt write-downs; and, (v) it can delay necessary reforms thereby requiring larger policy adjustments to be implemented when action is eventually taken. In response to these deficiencies, this paper argues that, for reasons of equity and efficiency, private creditors should play a greater role in risk-sharing and helping to resolve sovereign debt crises. We propose the introduction of two complementary types of state-continent bonds — ‘sovereign cocos’ and ‘GDP-linked bonds’.

Keywords: international monetary system; state contigent debt (search for similar items in EconPapers)
JEL-codes: F33 G01 G28 (search for similar items in EconPapers)
Pages: 20 pages
Date: 2013-11-19
Note: http://www.bankofengland.co.uk/financialstability/Pages/fpc/fspapers/fs_paper27.aspx
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Citations: View citations in EconPapers (11)

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