One mechanism to mitigate the debt dilution problem is the inclusion of a seniority clause in sovereign debt contracts. In the event of default, creditors are to be paid off in the order in which they lent (the “absolute priority” or “first-in-time” rule). In this paper, the authors propose a modification of the absolute priority rule that is more suited to the sovereign debt context and analyze its positive and normative implications within a quantitatively realistic model of sovereign debt and default.
A Seniority Arrangement for Sovereign Debt
WP 15-07 - A sovereign’s inability to commit to a course of action regarding future borrowing and default behavior makes long-term debt costly (the problem of debt dilution).