The structure of sovereign debt of developing countries has evolved over time from illiquid bank loans to liquid bonds. Before 1990, sovereign countries borrow mainly from commercial banks in the form of syndicated bank loans, which are often customized to the government needs and rarely traded. After 1990, sovereign countries start to borrow mainly in the form of sovereign bonds, which are highly standardized and liquid on the secondary market. This change in the sovereign debt structure is accompanied with a reduction in the renegotiation length. Restructuring of bank loans is prolonged, taking on average 9 years. In early 1990s, even longer renegotiations were expected when governments start to borrow in terms of bonds from a large number of diffused creditors. In reality, however, it takes only 1 year on average to restructure bonds defaulted upon after 1990.
It is of policy relevance to understand why bond debt has shorter delays than bank debt. Delays are inefficient: the government suffers from losing access to international financial markets and the creditors cannot realize investment gains. It has been widely argued that faster debt restructuring would have helped major borrowing countries recover from crisis and restore the momentum of growth at an earlier stage. It is also theoretically relevant to understand ex-post renegotiation outcomes of bank debt and bond debt. Different renegotiation outcomes have direct implications on ex-ante borrowing and default incentives of the government for bank debt and bond debt.
In this paper, we argue that the secondary market plays an important role information revelation in reducing the renegotiation length. One important reason for inefficient equilibrium delays is private information. When the creditors’ reservation value is private information, the government uses costly delays as a screening device for the creditors’ type, and delays optimally arise in equilibrium. Moreover, the more severe is the private information, the longer the delays are. When we introduce the secondary market, the secondary market price conveys information about the creditors’ reservation and lessens the information friction. As a result, the equilibrium delays are greatly reduced.
We model the renegotiation of illiquid bank loans by adopting the dynamic bargaining game with private information in Fudenberg et al. (1985). A government defaults on its debt and negotiates with creditors over a new debt contract. Both parties discount the future at the same rate. During the renegotiation, the government suffers a loss in output, and the creditors can seize a fraction of the output loss, which forms their reservation value.
The reservation value is private information of the creditors, and the government is informed only about its distribution. In each renegotiation period, the government makes a debt restructuring proposal, and the creditors either accept or reject the proposal. If the creditors accept, the government repays the creditors the proposed offer and avoids the output loss. Otherwise, the renegotiation continues to the next period.
