Conditionality covenants: Commitment versus discretion in sovereign credit contracts

This paper investigates the impact of imposing conditionality covenants on the performance of the signatories to a sovereign credit contract. A two period model is developed in which creditors provide a loan to a sovereign conditional upon the implementation of investments. Commitment to these covenants overcome the debt repudiation problem, as it increases the likelihood of repayment, if the implemented conditionalities contribute to an increase in the sovereign's productive capacity. A three period model is also developed to entertain the possibility that the sovereign engage in credit activities in subsequent periods, where in the final period the debtor has obligations towards junior and senior creditors. This allows for dynamic inconsistency, as the sovereign may be tempted to increase its debt in the second period, thus increasing the probability of repudiation in the third period. Imposing conditionality covenants by senior creditors that increase the portion they can appropriate in case of repudiation, relative to junior creditors, reduces the supply of credit by junior creditors in the second period and thus overcomes the debt dilution problem. Copyright © 2009 John Wiley & Sons, Ltd.