Debt dilution, overborrowing, and sovereign default risk

We propose a sovereign default framework that allows us to quantify the importance of the debt dilution problem in accounting for overborrowing and sovereign default risk. We find that debt dilution accounts for 12% of the mean debt level and almost 100% of the sovereign default risk in the simulations of a baseline model. Even without commitment to future repayment policies and without contingency of sovereign debt, if the sovereign could eliminate the dilution problem, the number of default per 100 years in our simulations decreases from 2.72 with debt dilution to 0.01 without debt dilution. Our analysis is also relevant for the study of other credit markets where the debt dilution problem could appear.