Sovereign Debt and Moral Hazard: The Role of Collective Action and Contractual Uncertainty

The ambiguous phrasing of pari passu (equal treatment) clauses in sovereign debt contracts has long baffled commentators. We show that in the presence of asymmetric information on a sovereign borrower’s ability to pay, an uncertain clause gives rise to a collective action problem among creditors that can reduce sovereign moral hazard. By varying the clause, parties can calibrate a sovereign’s expected default costs and payments to creditors and thereby optimally trade off the sovereign’s moral hazard and (deadweight) default costs. As information asymmetry decreases, a pari passu clause becomes a coarser instrument for configuring creditors’ incentives and mitigating moral hazard.