contracts do not fully specify the states of nature in which the scheduled payments would not occur according to the ex-ante expectations that justify the compensation for taking risk. Thus, the scenarios in which sovereign debt restructurings are needed are not fully defined in the contracts, and when risks materialize such that a debt restructuring becomes necessary, creditors do not fully“lose” the rights 4 stipulated in those contracts, until they willingly accept an exchange offer, or are forced to do so via super-majority positions(such as those defined in collective action clauses included in the bonds). This opens the door for creditors’ litigation against sovereign debtors when the rights stipulated in the contracts are infringed, regardless of the economic circumstances that led to the infringement. 5 In practice, in situations of debt distress, creditors generally fail to recognize the ex-ante rationale for a risk premium. The usual situation features a delay from every side in recognizing the sustainability problem followed eventually by the start of a debt negotiation featured by disagreements based on competing interests among all stakeholders – the debtor versus the creditors, and among the creditors(Brooks et al., 2015), with creditors often arguing that they should be entitled to receive a high interest rate, even after a restructuring that allegedly restored sustainability, which would imply that there would be no justification for such a high interest rate. Conflicts arise whose resolution is generally protracted and highly costly given the absence of an international rule of law. The costs of delay may be very high: the uncertainty associated with unresolved macroeconomic debt crises has aggregate demand and supply effects that lead to underutilization of the factors of production of the economy. There are negative externalities of these aggregate demand effects, hence the social costs of delay are generally larger than the private costs, making a market-based solution inefficient(Stiglitz, 2010). The costs may be so large that both the creditors and the debtor can be worse off as a result. However, the delay may be costlier for one side than the other: typically, the debtor country suffering the crisis is in a bigger rush to stop the escalating social and political unrest than the bondholders that can more patiently wait for a resolution that is more favourable to their interests. 4. The key questions for a DSA The first question of a DSA is: Under the current set of policies, is debt sustainable with high probability? If the answer to the first question is negative, the next question of the DSA is: Are there feasible alternative policies that would make debt sustainable with high probability? The objective at this stage is to assess whether there are policy adjustments that would ensure debt sustainability with high probability, such that a debt operation that involves relief can be avoided. As we will see below, the endogenous effects of policies need to be considered when addressing this question– for example, a public spending cut to improve the fiscal balance will likely decrease economic activity; hence it will decrease tax revenues. If the answer to the previous question is also negative, then the DSA formulates a third question: What is the size of relief that would take the debt to a sustainable position with high probability? The DSA at this stage provides guidance for a debt restructuring. 4 As we have explained, under incomplete contracts that include a compensation for risk, those“rights” are ambiguous. In the case of a debt contract, when the debtor fails to fulfill some term in the contract, even if there was a compensation for the risk of such“failure”, the creditor has to decide that the failure is a triggering event. The contract specifies what happens next, but the remedy may not be fully defined in the contract. For corporations, bankruptcy laws are meant to complete the contract. For sovereigns, there is no such mechanism, and judges’ discretion often gets larger, as it happened in the dispute between Argentina and the vulture funds following the 2001 country’s debt default(Guzman and Stiglitz, 2014; Chodos, 2016). 5 Debt contracts could, of course, specify certain situations where the creditor is not entitled to full repayment, e.g. acts of war or nature that make it impossible to repay, but typically they do not do so. More recently, some bonds specify conditions, like hurricanes, in which there can be postponement of repayment. Series: Debt Sustainability Assessments& Their Role in the International Financial Architecture 3