When sovereigns selectively default
I’ve lost count of how many times I’ve recommended James Macdonald’s excellent book A Free Nation Deep in Debt: The Financial Roots of Democracy to people interested in the connections between democracy, development, and debt capital markets. So I’m very chuffed that Macdonald has popped up in the comments on this blog to talk about the historical precedents behind Ecuador’s decision to repudiate some of its old debts, while staying current on certain of its newer debts.
His comment is, naturally, worth quoting in full:
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 Ecuadorean (and Latin American) history since liberation from Spain.
Madonald is right, of course, but it’s also worth noting that “the idea of different treatments accorded to different types of debt” is not something old which is being rediscovered — in many ways it never went away. The international community, including established debtor nations like France and the UK, even enshrined it in the concept of “preferred creditor status” — the idea that the IMF and the World Bank should always be senior to bondholders. And the Brady plan was basically a plan to turn sovereign loans into sovereign bonds on the grounds that while lots of countries had defaulted on their bank loans, none had defaulted on their global bonds, and as a result global bonds were considered safer or more senior than bank loans.
Anna Gelpern has written extensively about this issue: the big difference between sovereigns and corporates is basically that sovereigns are constructively ambiguous about which debts they consider senior to which other debts. “Sovereign immunity,” she writes, “empowers a government to choose the order of repayment among its creditors based on political imperatives, financing needs, reputational concerns or any other considerations”. The answer to this problem is not the idea that all governments should always pay all their debts in full — after all, sovereign credit risk has always existed and will always exist. Instead, a more formal system of transparent and enforceable seniority could make debt markets more efficient and debt restructurings less ugly.
For the time being, however, if and when there’s another wave of sovereign defaults, it’ll be largely up to each individual country which debts they choose to default on. Will it be foreign-currency debts, like Argentina, or domestic-currency debts, like Russia? Will it be bonds, or loans, or both? What will they do with trade finance and other vital short-term credit lines? And where will the multilaterals stand? No one ever knows, until the default actually happens.
Update: Yet more from Macdonald in the comments.