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NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 2010

While all errors are our own, we thank Rui Esteves, Daniel Klerman, Lee Ohanian, Christoph Trebesch, the editor, three anonymous referees, and numerous seminar participants for comments, and Catherine Feng and Aubrey Clark for excellent research assistance. Further comments are welcome. Pitchford acknowledges the financial support of the Australian Research Council. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. © 2010 by Rohan Pitchford and Mark L. J. Wright. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Holdouts in Sovereign Debt Restructuring: A Theory of Negotiation in a Weak Contractual Environment Rohan Pitchford and Mark L. J. Wright NBER Working Paper No. 16632 December 2010 JEL No. D23,D78,F34,K12,K33 ABSTRACT Why is it difficult to restructure sovereign debt in a timely manner? In this paper we present a theory of the sovereign debt restructuring process in which delay arises as individual creditors hold-up a settlement in order to extract greater payments from the sovereign. We then use the theory to analyze recent policy proposals aimed at ensuring equal repayment of creditor claims. Strikingly, we show that such collective action policies may increase delay by encouraging free-riding on negotiation costs, even while preventing hold-up and reducing total negotiation costs. A calibrated version of the model can account for observed delays, and finds that free riding is quantitatively relevant: whereas in simple low-cost debt restructuring operations collective mechanisms will reduce delay by more than 60%, in high-cost complicated restructurings the adoption of such mechanisms results in a doubling of delay.

Rohan Pitchford Research School of Economics Australian National University Mark L. J. Wright Department of Economics University of California, Los Angeles Bunche Hall 9284 Box 951477 Los Angeles, CA 90095-1477 and NBER


Negotiations to restructure sovereign debt are time consuming, on average taking more

than six years to complete. Such delays are puzzling because they are costly to all parties: Sovereign debtors in default face disruption in their access to world capital markets, while creditors suffer large losses in the value of their investments. Why are delays so long? In this paper, we develop a theory of sovereign debt restructuring negotiations based on the observation that it takes place in a weak contractual environment, where the sovereign cannot commit to making identical settlement offers to all creditors. Delay then arises endogenously due to a strategic holdout effect whereby creditors delay entering into a settlement in the expectation of better terms at a later date. Motivated by a number of recent cases and the ensuing policy debate,1 we use the theory to examine whether strategic holdout is overcome by collective action mechanisms, i.e. policies which bind holdout creditors to agreements negotiated by a group of earlier settling creditors. Our most striking result is that collective action mechanisms can actually increase delay due to an offsetting free-rider effect in which creditors free-ride on the negotiation efforts of other creditors. In a calibrated version of the model, we show that collective action mechanisms can more than double delay for an empirically significant subset of restructurings. To understand the mechanism underlying our theory, note that the legal...
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