Avoiding sovereign debt dilution with debt seniority

There is a natural tendency for firms to borrow too much. This is known as the debt dilution problem. It occurs because the borrower does not factor in the impact on old debt of borrowing more. Indeed, it makes old more risky, and hence increases borrowing costs. The market response to this problem was to introduce debt seniority, wherein some debt classes have priority over others in liquidation. For example, primary mortgages have priority over secondary mortgages, and the latter carry higher interest rates. The fact that one has a secondary mortgage has then no bearing on the riskiness and cost of the primary mortgage.

Satyajit Chatterjee and Burcu Eyigungor point out that there is not such concept in sovereign debt, but it should. Indeed, debt dilution happens at a massive scale in sovereign debt, and the market response when debt dilution happens such as now in many countries is to have shorter terms. This increases costs significantly, as Southern European countries have recently witnessed. Chatterjee and Eyigungor show that if sovereign debt also had a seniority structure, the frequency of default would be significantly reduced, by 40% taking the example of Argentina. It also reduces the volatility of spreads by two thirds. That seems very interesting.