Investment patterns and distortions in the presence of a sovereign debt overhang

This dissertation provides the necessary framework for addressing the sovereign debt overhang problem in an orderly fashion by taking into consideration the three most recent economic crises that pulled the global financial architecture into a downward spiral in which both sovereign debtors and creditor banks incurred tremendous losses.; It focuses on the analysis of the various liquidity constraints, and disincentive effects and stresses specifically the investment distortions associated with the existence of the sovereign debt overhang in the capital structure of the highly indebted emerging and transition economies.; It consists of five chapters and is organized in the following manner: Chapter I examines in an “ad-hoc” manner a broad array of private and public sovereign investment data and draws robust inferences about trends in investment behavior in emerging economies during the three most recent financial crises. Chapter II employs a “tour-de-table” approach and uses selected banking data in order to analytically explain the involvement of the major Western banks in the “Sovereign-Debt” and the “Global-Asian” financial crises respectively. Chapter III considers an analytical sovereign debt overhang framework and specifically focuses on the investment distortions that exist. It develops and derives multiple sovereign debt equilibria that are ranked by using the Pareto criterion. The analysis incorporates both the illiquidity and the disincentive effects of the debt overhang and concludes that the welfare effects of sovereign debt forgiveness are indeterminate. Chapter IV stresses the need for sovereign debt reduction and indicates how a financial package involving a sovereign debt swap can lead to a Pareto improvement in welfare. It specifically focuses and develops a menu of alternative sovereign debt relief schemes in order to alleviate the debt overhang issue and obtain efficiency gains in order to achieve Pareto optimality. Chapter V develops an intertemporal theoretical model of debt overhang and derives optimal conditions for sovereign debt relief. A set of efficient and inefficient conditions is obtained based on the investment strategies that a creditor bank follows.