When sovereigns selectively default

By Felix Salmon
May 29, 2009

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.

10 comments

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Quoting myself, in full, from your blog:

“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.”

I think that I came to the same conclusion that Macdonald did without fannying about in the Napoleonic Wars. I arrived at my conclusion using the far superior method of philosophers and novelists of sitting in a comfortable chair, eating a few cookies ( Did you ever find out about Chocolate Olivers for me? ), and mulling the question over for a not too lengthy amount of time. And you can quote me in full about that.

This discussion is very focused on the bondholders’ position on repayment issues.

But I am curious about the question of the legitimacy of the issuance of the bonds. The ultimate payor of a sovereign bond is the taxpayer of the nation. But if the bonds were issued by a dictatorship whose military control of the government is not ratified by the voters in a representative democracy, how is that issuance binding on a later democratically elected government?

I ask this for two reasons (and I don’t know the answer): 1) I have seen passionate tracts in Chile and Argentina in the 1990s arguing that debts incurred by the dictators to support their military rivalries are invalid; and 2) in the US there is a whole industry of bond attorneys who charge real money to ensure that the authorization of the issuance of municipal bonds was properly conducted by duly elected and/or appointed officials acting within the scope of their authority, etc., etc.

How is that managed in the sovereign debt arena?

Posted by dollared | Report as abusive

You are right that the idea of differentiating between debts has never really gone away. However, there is an important difference between what Ecuador is doing and the concept of “preferred creditor status,” or the idea that bonds should be senior to bank debt. Ecuador is making retrospective judgments about the moral legitimacy of debts that have nothing to do with the terms on which they were originally contracted.

Anna Gelpern is right that an established order of priority might help in sovereign debt restructurings. However, since the practice of selective default on the basis the current regime’s ideological preferences is, by definition, a repudiation of the legality of prior commitments, I doubt that this will solve the problem.

I would also like to note that the current legal climate is becoming a fertile ground for justifications for selective default based on ideological preferences. Take two examples:
1. ‘Odious’ debts incurred by corrupt dictators who have used the money to oppress the population while lining their own pockets.
2. Debts bought by ‘vulture’ funds at a deep discount and then taken through the courts for payment.

In both these cases, it is easy to understand the kind of moral outrage that justifies selective default. However, the hard lessons of history have suggested that contracts should be adhered to even when moral feelings suggest otherwise.

1. It would have been easy for Restoration France to have repudiated the Napoleonic debts as the product of an odious and illegal regime.
2. The question of vulture funds goes straight back to the debate between Madison and Hamilton about the refunding of the revolutionary debt. Madison could not bear the idea that much of the debt had been bought at a discount by speculators. Hamilton argued that if the country wished to establish its credit, it needed to honor its debts regardless of who owned them.

Baron Louis won the debate in France, and Hamilton won the debate in America. I doubt very much that either country would have been able to borrow so cheaply over the following centuries if they had not done so.

PS I have been meaning to thank you for the number of occasions on which you have recommended my book!

Posted by James Macdonald | Report as abusive

Two typos here, lont and “did so on for France”. Please quote the man correctly, or use an editor.

-Dwight

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 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. before 1815.

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