A widely proposed remedy is the inclusion of seniority clause in sovereign debt contracts: Creditors who lent first have priority in any restructuring proceedings. The authors incorporate seniority in a quantitatively realistic model of sovereign debt and find that seniority is quite effective in mitigating the dilution problem. The authors also show theoretically that seniority cannot be fully effective unless the costs of debt restructuring are zero.
Debt Dilution and Seniority in a Model of Defaultable Sovereign Debt
WP 13-30 - An important inefficiency in sovereign debt markets is debt dilution, wherein sovereigns ignore the adverse impact of new debt on the value of existing debt and, consequently, borrow too much and default too frequently.