The maturity structure of sovereign debts within a solidarity zone

Abstract

This paper characterizes the optimal bailout maturity structure for a sovereign on the verge of a default. I find that buying back long-term debt is strictly optimal when it can prevent a default today and in the future. Otherwise, buying back short-term debt is optimal and can prevent a default only today. The paper also investigates the choice of debt maturity structure of the sovereign in the presence of bailouts. I find that potential bailouts extend the sovereign’s borrowing capacity and make it rely more on debt with shorter maturities on average. As short-term debt is vulnerable to rollover crises, it generates more default risk. Eventually, the paper analyses how potential bailouts affect ex post welfare and studies ex ante welfare-improving policies.