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

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 ambiguous pari passu clause gives rise to a collective action problem among creditors that can reduce sovereign moral hazard. By varying the clause ambiguity, parties can induce an (ex-ante) optimal probability of costly renegotiation breakdown resulting from creditors' failure to coordinate. As information asymmetry decreases, a pari passu clause becomes a coarser instrument for configuring creditors' incentives and thereby resolving moral hazard.