Oxford Review of Economic Policy, 2023, 39, 367–378 https://doi.org/10.1093/oxrep/grad012 Article Creating a new sovereign debt reconstruction mechanism: why incentives, risk sharing, and CACs will all matter Gordon Menzies * and David Vines ** * University of Technology Sydney, Australia, e-mail: gordon.menzies@uts.edu.au ** University of Oxford, UK, e-mail: david.vines@economics.ox.ac.uk Gordon Menzies would like to thank Margaret Meyer and staff at the IMF for helpful discussions. Abstract This paper argues that the Covid recession, and aggressive monetary tightening in the US accompanying the post-Covid recovery, are likely to cause a sovereign debt overhang in emerging market economies—i.e. debt which is unlikely to be fully repaid. A sov- ereign debt reconstruction mechanism (SDRM) seems necessary to avoid widespread disorderly debt write-downs. We discuss a range of procedures that are available, building upon Anne Krueger’s proposal for an SDRM in 2002 (Krueger, 2002a,b). At that time Krugman (1988) had already argued that any SDRM should incentivize debtors so that they put in effort to clear their debts (a Krugman contract). Menzies (2004) went further than this to show that these effects should be further sharpened, creating what he called ‘hyper-incentive effects’ (a Menzies contract). The International Monetary Fund has argued that risk-sharing between debtors and creditors will also be important (IMF, 2020). But we show that risk-sharing will—in general—pull in the opposite direction to incentive effects, and we doubt the extent to which the IMF has recognized this trade-off. Finally, we argue that col- lective action clauses (CACs) increase the probability of achieving any agreement, whatever it might be. They will help avoid the alternative of disorderly debt write-downs, outcomes which will deliver neither incentive effects nor risk-sharing. Keywords: debt overhang, debt forgiveness, hyper-incentive contract, collective action clauses JEL classification: F34 I. Introduction The tumultuous events of the Covid recession and recovery, and the subsequent monetary tightening, may come to remind sovereign debtors of the early 1980s. Back then, entrenched infation following two 1970s oil price shocks encouraged the Federal Reserve to double interest rates, setting in train a worldwide recession and leaving many developing countries with a troika of high oil prices, high interest costs, and low commodity prices. This created a ‘debt overhang’, by which we mean the presence of an existing inherited stock of debt suffciently large that creditors cannot expect with confdence to be fully repaid. It seems likely that the world economy is now headed in the same direction, with Ghana, Lebanon, Sri Lanka, Suriname, Ukraine, and Zambia all recently signalling repayment diffculties. At the start of 2023, development experts and economists have been highlighting the need for creditor coordination and additional fnancing for these countries, and the Debt Justice Network NGO has warned that well over half of lower-income countries are vulnerable to debt default in the aftermath of the recent global monetary tightening (Elliott, 2023). As a result, we believe that the international fnancial architecture now requires the creation of a sovereign debt reconstruction mechanism (SDRM). In the 1980s, immense suffering was caused by the debt overhang. By ruling out any reduction in the net present value (NPV) of debt stocks, immovable stocks of debt hung over the debtor economies in Latin America, stunting © The Author(s) 2023. Published by Oxford University Press. For permissions please e-mail: journals.permissions@oup.com Downloaded from https://academic.oup.com/oxrep/article/39/2/367/7113978 by guest on 13 April 2023