The Perils of Bilateral Sovereign Debt

Motivated by the emergence of new official creditors outside the Paris Club framework, we study the interaction between senior official lending and market debt. We develop a quantitative sovereign default model featuring a large senior lender with whom borrowing terms are negotiated. Obtaining more net financing from the market strengthens the government’s bargaining position and improves bilateral terms. This endogenous cross-elasticity erodes the discipline of spreads and amplifies debt dilution, leading to welfare losses even as bilateral borrowing helps avert some defaults ex-post. With pre-specified rules, rewarding market issuance can be enough to generate such losses, and an optimal rule instead raises bilateral rates with net market financing. The direction of the cross-elasticity can thus guide in practice the assessment of new forms of bilateral sovereign debt.