Creating a new sovereign debt reconstruction mechanism: why incentives, risk sharing, and CACs will all matter.

This article analyzes the risk of a sovereign debt overhang in emerging market economies following the Covid recession and subsequent US monetary tightening, arguing for the necessity of a sovereign debt restructuring mechanism (SDRM) to prevent disorderly debt write-downs. Building on Anne Krueger’s 2002 SDRM proposal and earlier work by Krugman (1988) and Menzies (2004), the paper emphasizes the importance of incentive-compatible contracts—distinguishing between “Krugman contracts” that motivate debtors through debt forgiveness alone and “Menzies contracts” that add bonus payments (“hyper-incentives”) to further encourage debtor effort in clearing debts. The authors develop a formal model showing that optimal SDRM design must balance debtor incentives and risk-sharing, noting that recent International Monetary Fund (IMF) practices emphasizing risk-sharing may underappreciate the trade-off with incentives. Additionally, the paper highlights the role of collective action clauses (CACs) in facilitating agreements among creditors to avoid inefficient, disorderly workouts, and concludes that an SDRM combining incentive alignment, risk-sharing, and CACs should be integrated into the international financial architecture.