Opinion

Felix Salmon

The cost of sovereign default turns negative

By Felix Salmon
May 26, 2009

Ecuador has closed out its bond exchange offer at the higher end of expectations, paying 35 cents on the dollar to investors who hold the 2012 and 2030 global bonds. That’s higher than the bonds have traded all year, and certainly higher than they have traded since Ecuador defaulted — which means that any vulture investors who bought the bonds in default will be able to lock in a decent profit for doing essentially no work at all.

What’s more, Ecuador has announced that anybody who put in an offer higher than 35 cents will be allowed to re-tender at the 35 cent level. This makes sense from Ecuador’s point of view, and gives people who tendered high the opportunity to re-think their strategy in the light of known events. It’s pretty clear that at this level a supermajority of the total bonds outstanding will end up being owned by Ecuador — which means that Ecuador will have the ability to strip a lot of creditor protections out of the instruments.

Ecuador has suffered no negative repercussions from its actions — quite the opposite. If the country needs any money in the next few years, it’ll be able to get it, from the Andean Development Bank or the Inter-American Development Bank or the World Bank or even the International Monetary Fund. None of them seem to particularly care that Ecuador defaulted on its global bonds, and emerging-market bondholders are so weak and fragmented these days that they hold very little sway any more within international financial institutions.

Indeed, given the short memory of emerging-market bondholders, I wouldn’t be surprised to see Ecuador regain its access to the international capital markets within a few years, thanks to the way in which it has managed to substantially reduce its (already pretty low) debt-to-GDP ratio. That could well be the thinking behind the decision to remain current on the 2015 global bonds, which were issued when current president Rafael Correa was finance minister. Look, he’s saying: we pay back the money that we borrow. We just don’t pay back debt which was originally borrowed decades ago and which was restructured twice in a manner designed to be as friendly as possible to private-sector creditors.

Looking at this from a systemic perspective, it’s pretty clear that in this instance the cost of default, to Ecuador, was negative. That’s dangerous: it radically increases the probability of tactical defaults from all manner of other countries, including Argentina, Venezuela, and various African states. And once a wave of sovereign defaults starts, it’s very difficult to stop, since the cost of default drops with each new event. Right now the risk of such a wave is surely near a multi-decade high.

Comments
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You contradict yourself. You say that Correa sent the clear message that “we pay back the money that we borrow. We just don’t pay back debt which was originally borrowed decades ago and which was restructured twice in a manner designed to be as friendly as possible to private-sector creditors.”

The fact that the market reacted this way only suggests that there was indeed a debt overhang and that Correa has managed to restructure obligations in a way that pulls off a deal both for his country AND for potential future investors. With less debt overhang future cashflows that might have gone to pay off those old debts can be more credibly pledged to new investors.

The only danger I see you allude to is that other countries might try to do the same more clumsily in a way that leads markets to irrationally over-react.

But doesn’t the problem then lie with markets that overreact? Should we tell poor developing countries (or under-the-water house mortgage borrowers in the US for that matter) that they should never attempt to restructure past debts because if they do the markets might get spooked in ways that affect others?

We always seem to be willing to bail out or otherwise protect the unsecured creditors because of the fear that ‘panic’ would spread! An element of truth no doubt, but also awfully convenient.

Posted by arrow | Report as abusive
 

I think that if you look at the history of emerging market debt, especially pre WWII, it was standard practice for sovereigns to default and renegotiate when things got tough.

This was dealt with by charging them a higher rate when the loan was originated.

Overall the loans were a reasonably good deal but payment streams were erratic.

In the last few decades the financial orthodoxy has strongly discouraged this. This has been backed up with an infrastructure including the IMF, etc.

It is not at all clear that the current approach is better than the older one.

There are also real issues where dictators make loan agreements, pocket them money for personal gain, and then a democracy comes in.

Should the new government ruin its credibility with its voters following painful fiscal polices to pay back what many consider illegitimate debts?

Posted by dk | Report as abusive
 

It actually isn’t clear that Ecuador ever had sustained market access after its Brady restructuring left it with a pretty high level of debt relative to its political capacity to pay. It got a small loan from Chase in 97 I think, a loan that was turned into a bond but never really successfully syndicated (if memory serves). I forget the conditions of the 2005 issuance but at least a portion of it was sold to vennie, and on net, ecuador has been clearly been paying more to the bond market (coupons on the 12 and 30) than it has received in new money from the int. bond market — mostly because it wasn’t clear that Ecuador’s debt was at a level where there was really political consensus to pay it. Certainly Ecuador has been making net payments to bondholders (i.e. paid more in interest than receiving in new money) since its Brady deal. Market access was sporadic at best even when oil prices were high.

All this makes me suspect that Ecuador wasn’t going to have much access to the market if it paid in full (not when oil revenues are short of what Ecuador needs to sustain its current level of imports/ ecuador needs to go through a deflationary period of adjustment) and probably won’t get much access to the market now.

Posted by bsetser | Report as abusive
 

“And once a wave of sovereign defaults starts, it’s very difficult to stop, since the cost of default drops with each new event. Right now the risk of such a wave is surely near a multi-decade high.”

One thing I’m sure of is that anyone can concoct a convincing argument as to why they shouldn’t have to pay back money. At least, an argument that convinces them.

At some point in this crisis, the statement that this is a peculiar and particular event that is self-contained and influences nothing else is going to wear thin. When AIG was bailed out, every business in the country took notice. I can’t believe that other countries aren’t interested in what Ecuador seems to be accomplishing, or that they can’t come up with similar excellent reasons to stiff or trim creditors. We are talking about human beings, after all.

 

Interesting development and timely piece Felix. Are you familiar with Kyle Bass of Hayman Capital (he also predicted & profited from the housing crisis like Paulson). Bass has been clamoring in the background that sovereign defaults are the next big event in line: http://www.marketfolly.com/2009/05/hayma n-capitals-kyle-bass-predicts.html

 

which hihlights argentina’s folly in 1984 of not repudiating the odious debt largely generated by the military dictatorship and multiplied by the thugs’ crony reagan`s interest rates, at a moment it was holding manny hanny et al by the short and curlies

 

One of the interesting features of this default is the revival of the idea of different treatments accorded to different types of debt. There is a long history of such practice. The main purpose has always been to gain the short-term cost benefits of default without incurring the lont-term penalty of reduced access to the credit markets.

In this case, the regime treats its own debts as legitimate while treating those of its predecessors as illegitimate (or at least less legitimate). Eighteenth- century France used a different technique: treating previously defaulted debts as immune to further write-downs, while more recent debts were viewed as fair targets for default because their interest rates were, not surprisingly, considerably higher and could therefore be deemed usurious.

After the Napoleonic War, France finally became a reliable borrower, and one of the main demonstrations of this was honoring the Napoleonic debts in spite of the temptation to repudiate them. It was argued at the time that this was not merely a matter of good faith, but rather an unavoidable price for access to the credit markets on favorable terms as enjoyed by Great Britain.

To my mind, this remains a valid argument. Historically, default almost always had a negative short-term cost – it certainly did so on for France before 1815. The regime always had access to new loans after each bankruptcy; but its access to credit was limited by its previous track record. Attempting to justify its actions by differentiating between types of debt did not fool creditors. They may have continued to lend, but always at rates that factored in the risk of default, and in amounts considerably lower than they were willing to lend to Great Britain.

Just because Ecuador currently experiences a short-term gain will not turn it into a good credit risk. Only paying debts regardless of short-term incentives to default will remove it from the vicious cycle of borrowing and default which has mired Ecuadorian (and Latin American) history since liberation from Spain.

Posted by James Macdonald | Report as abusive
 

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