Given the potentially high productivity of investment in the capital-poor regions of the world, the current absence of investment flows to LDCs suggests that the external debt overhang is inhibiting the efficient international allocation of capital. Inefficiencies in the post-default negotiation of sovereign debt repayments and new capital flows between debtors and private sector creditors may justify intervention by creditor country governments and international institutions. In Discussion Paper No. 357, Kenneth Kletzer analyses sources of inefficiency in the renegotiations between private creditors and debtor governments.
The flow of new resources for capital formation is distorted by legal privileges accorded to existing creditors by their governments, Kletzer argues. The seniority privileges for old lenders transfer to them some of the social returns to new investment, away from those who might provide the new investment. Legal privileges provide reservation levels of utility for old creditors, which can inhibit coordinated lending.
There are no mechanisms for credible commitment of lenders to a coordinated policy in the event of default. This inhibits new capital flows to heavily indebted countries even when further lending is socially efficient. Cooperative equilibria for the coalition of lenders may be unattainable because institutional distortions create time consistency problems. Institutions which create legal privileges and provide mechanisms for credible commitment by some of the parties to a long-term relationship play a major role in bargaining. Kletzer develops a simple dynamic model of the basic institutional and informational environment of renegotiation. The motivation for borrowing from abroad is to smooth consumption over time when national income is subject to random shocks. This contrasts with a repeated static framework because the sanctions available to creditors to punish a repudiating debtor are imposed in future periods, rather than in the current period.
Time inconsistency arises because lenders cannot commit to accept future net transfers which, in some contingencies, they will wish to renegotiate. Repayment schedules contingent on future states of the world may permit efficient equilibrium paths for capital flows. Such a plan requires that the repayment schedules be binding on the creditors. Ex post renegotiations of debt contracts conveying seniority privileges may not lead to equivalent outcomes, however, because creditors cannot precommit.
Information asymmetries create an additional distortion in the bargaining process with seniority privileges, according to Kletzer. A debtor who would be willing to repay in full may be able to renegotiate debt service obligations to its advantage. He constructs a model of strategic bargaining with asymmetric information about the government's social preferences, capturing the constraints the domestic political environment places on debt service. Creditors delay agreement in order to elicit private information, and the consequent suspension of new inflows for capital formation is socially costly.
Kletzer's analysis distinguishes between implicit contracts made ex ante as state-contingent claims and those that exchange resources for an ability to impose sanctions whose value is negotiated ex post. He argues that they are fundamentally not equivalent, due to legal privileges. He urges investigation of official alienation of these privileges, increased regulation of private capital flows, and introduction of alternative instruments to provide capital flows to developing regions

Inefficient Private Renegotiation of Sovereign Debt
Kenneth M Kletzer

Discussion Paper No. 357, December 1989 (IT)