Sovereign Debt

From Safety to Default

Rob Quail, Robert W. Kolb

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470922392
• eBook ISBN: 9781118017555
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

An intelligent analysis of the dangers, opportunities, and consequences of global sovereign debt

Sovereign debt is growing internationally at a terrifying rate, as nations seek to prop up their collapsing economies. One only needs to look at the sovereign risk pressures faced by Greece, Spain, and Ireland to get an idea of how big this problem has become. Understanding this dilemma is now more important than ever, that's why Robert Kolb has compiled Sovereign Debt. With this book as your guide, you'll gain a better perspective on the essential issues surrounding sovereign debt and default through discussions of national defaults, systemic risk, associated costs, and much more. Historical studies are also included to provide a realistic framework of reference.

• Contains up-to-date research and analysis on sovereign debt from today's leading practitioners and academics
• Details the dangers of defaults and their associated systemic risks
• Explores the past, present, and future of sovereign debt

The repercussions of a national default are all-encompassing as global markets are intricately interwoven in the modern world. Sovereign Debt examines what it will take to overcome the challenges of this market and how you can deal with the uncertainty surrounding it.

PART I

The Political Economy of Sovereign Debt

The chapters that comprise this section focus on the most sweeping issues of sovereign debt—the role that this debt plays in the essential economy of a nation and how sovereign debt interacts with societal dimensions beyond the merely financial. As the introduction has tried to make clear, sovereign debt has a worldwide economic importance that it has never had before, and this is due to the economic difficulties and societal challenges faced by so many of the heretofore most successful nations of the world. Accordingly, this section focuses on the overarching theory of sovereign debt, the levels of debt that nations can sustain, the problem of default, and the sanctions that lenders use to enforce their claims against governments that are reluctant to pay as promised.

In addition, these articles examine the effect of sovereign debt and defaults on the overall economic productivity of a nation. Further, some of the most egregious episodes in the history of sovereign debt arise from countries with a “resource curse”—a valuable resource that promises a horn of plenty but that has historically been associated with slow economic growth and a reluctance or inability to pay on sovereign debt.

A sovereign’s ability to conduct war depends on money. As Cicero noted more than 2,000 years ago, “Endless money forms the sinews of war.” Had Cicero lived in our time, he might have added: “And many nations attempt to fashion these sinews from debt,” as many nations have attempted to construct these sinews by issuing sovereign debt, and success or failure in sovereign debt management has meant victory or defeat in many wars. Thus, sovereign debt connects with matters of great societal import—in some instances, sovereign debt determines the very survival of the state and society.

Chapter 1

Sovereign Debt

Theory, Defaults, and Sanctions

Robert W. Kolb

Professor of Finance and Considine Chair of Applied Ethics, Loyola University Chicago

For more than 2,000 years, sovereign governments have borrowed and frequently defaulted. In many instances, the sovereign borrower possessed overweening power compared to the unlucky lender, leaving the hapless creditor little or no means of collecting the debt. In more recent historical times, sovereign borrowers have been smaller, weaker, and poorer nations, and their lenders have been financial institutions lodged in the world’s most powerful states. On some occasions, those lenders were able to enlist the military power of their own countries to enforce their private claims against the sovereign borrowers to make them pay. (These governments were presumably willing to use their military power on behalf of their financial institutions because doing so met the perceived interests of the governments themselves, or at least the interests of those individuals who held office.)

These episodes of gunboat diplomacy or supersanctions were quite effective and far from rare in the period of 1870–1914, a time of widespread adherence to the gold standard in exchange rates. A clear instance of gunboat diplomacy occurred at the turn of the twentieth century. A revolution in Venezuela that began in 1898 destroyed considerable property, and the government stopped paying its foreign creditors. In response, Great Britain, Germany, and Italy blockaded Venezuelan ports and shelled coastal fortifications, compelling Venezuelan compliance. The experience of Egypt provides an example of a nongunboat supersanction. Under the leadership of Isma’il Pasha from 1863 to 1879, Egypt borrowed and spent, notably to finance a war with Ethiopia. Unable or unwilling to pay these debts as promised, Pasha sold the Suez Canal to Great Britain in 1875. With Egypt’s debts still not satisfied, Great Britain pressured the Ottoman sultan to depose Isma’il and replace him with his son Tewfik Pasha in 1879. In response to a period of missing debt payments and internal unrest, Great Britain took effective control of Egypt’s finances in 1882 and directed Egypt’s financial resources to the repayment of its foreign debts.1

Today, attempts to secure repayment by gunboat diplomacy or seizing another sovereign state’s finances are considered a bit outré, a circumstance that leads to the two central questions of the theory of sovereign debt: If the creditor cannot force the sovereign borrower to repay, why would the sovereign ever do so? Correlatively, without an ability to force repayment, why would any potential creditor ever lend to a sovereign borrower? The theory of sovereign debt addresses these two puzzles.

Before turning to a direct consideration of these issues, three preliminary points deserve mention. First, sovereign borrowers typically really do hold a different position from mere individuals or firms that borrow. While ordinary borrowers can be forced to repay through legal sanctions, sovereign borrowers today completely escape supersanctions and largely evade effective legal sanctions that might force repayment. Second, even in the post-supersanction period, and even with the inability to enforce collection with legal sanctions, sovereign lending remains quite robust. Despite a large number of defaults, sovereign debt is mostly repaid as promised. Third, the theory of sovereign debt attempts to explain the occurrence of lending and repayment in strictly economic terms. That is, the explanations that economists offer turn merely on the self-interest of the lender in extending credit and the borrower in making repayments. Economists never attempt to explain lending or borrowing behavior by reference to any moral obligation of fulfilling the promise to repay that borrowers make when they secure loans.

REPUTATIONAL EXPLANATIONS

One of the key rationales offered to account for the existence of sovereign lending turns on reputation. The argument asserts that sovereign governments want to maintain a reputation as a good credit risk to assure future access to international funds, so they repay the debts they owe now. As a result, lenders feel sufficient confidence to extend funds. There is no doubt considerable, yet somewhat limited, truth in this view. But the desire for continuing access to funds works hand in hand with the sanctions that do still prevail in the arena of sovereign debt. While these sanctions fall considerably short of the supersanction of invasion, they can have considerable force. For example, if lending institutions can punish a small developing nation that defaults by interfering with its international trade or by seizing that nation’s assets held abroad, these sanctions can provide additional reasons for debtor countries to repay. Thus, the threat of sanctions also stimulates countries to repay. So reputational concerns interact with responses to limited sanctions to encourage sovereign debtors to pay.

From the point of view of theory, however, there is a question of whether reputational considerations alone are sufficient to make sovereigns pay. In the parlance of the theory of sovereign debt, if the value of a good reputation is sufficient to make lenders pay as promised and sufficient to encourage lenders to extend funds, then reputation is said to support sovereign lending.

To simplify matters, assume that there is a single lender (or that all lenders act monolithically), and if a country defaults, it is excluded from borrowing forever. Several studies advance reputation as grounds for sovereign lending (Eaton and Gersovitz 1981; Eaton, Gersovitz, and Stiglitz 1986). The first thing to notice about such theories is that they pertain to an environment in which borrowing continues infinitely, or at least indefinitely from year to year. If the borrower knows that the current year is a terminal year, after which there will be no lending, the borrower would refuse to repay for the simple reason that there is no fear of exclusion from future borrowing. But lenders, also knowing that the current year is the terminal year, would also recognize that they will not be repaid, so they will not lend for that final period. In the second-to-last year, the borrower would not repay because it would know it could not borrow in the terminal year for the reasons just given. But the lender is assumed to have the same information, so it would not lend in that penultimate year, because it would realize it would not be repaid. This argument of backward induction can be repeated for all years from the horizon back to the present, thereby showing that explanations of sovereign debt based on reputation alone can work only in an environment of perpetual lending and borrowing. Or at the very least, there must be some continuing probability of borrowing and repaying into the indefinite future.

If withholding future lending is the only sanction that lenders can impose, other potential breakdowns in lending arise. For simplicity, consider an environment of a single borrower and a single lender. Assume that the maximum debt capacity of the borrower is 100 units and the lender advances one unit in each loan up to this limit. When the debt capacity of the borrower reaches the limit of 100 units, the lender refuses to make new loans. However, at this point, the reputation for repayment has no prospect of securing future loans, because the borrower has borrowed so much it knows it can never borrow any more. In this situation, the threat of exclusion from future loans has no force, and a reputation for repayment has no value in securing future loans. Having reached this limit of borrowing with no future prospects for loans, the borrower would refuse to repay the loan. However, the lender will also recognize this prospect and will not allow that situation to arise.

But now consider the situation in which the lender has advanced 99 units of credit. The borrower knows that it cannot secure the additional loan of one unit of borrowing for the reasons just given. So the borrower will not repay the loan at the 99 units of borrowing. The lender, too, recognizes this rationale on the part of the borrower, so it will not be willing to fall into this position of extending credit up to 99 units either. The same process of backward induction that applied for each period from the terminal period back to the present also applies from some hypothetical upper loan limit back to an initial loan, with the result that the lender can never extend even the first loan.

These two thought experiments—when borrowers and lenders both know they have reached the last period for a loan or when they know that they have reached the upper bound of lending—show the limits to reputation alone as a rationale for explaining sovereign borrowing. In both cases, the certainty on the part of both lender and borrower makes the venture fail. Thus, it is uncertainty about the future that makes reputation valuable in sustaining lending. A borrower’s reputation for paying as promised possesses value because of the prospect of securing a loan or expanding borrowing in the future.

BEYOND REPUTATIONAL EXPLANATIONS FOR SOVEREIGN DEBT

There are further limits to the reputational understanding of sovereign lending. Consider a country that has fluctuating production due to variable weather or other factors that affect harvests. Such a country might need to borrow in lean years to finance consumption, while repaying outstanding loans when harvests are bountiful or at least normal. Given these circumstances, this country might engage in sovereign borrowing followed by repayment with many repetitions in this cycle. For convenience, assume that the borrower country has reached its credit limit. At first glance, it may seem that the debtor nation has a choice of repaying with the prospect of future borrowings or defaulting and bearing the risk of future macroeconomic fluctuations on its own account.

However, a famous paper (Bulow and Rogoff 1989) shows that this is a false choice. Consider a country that has been borrowing in hard times and repaying when times get better but that has now borrowed up to the maximum any lender is willing to advance. In this situation, the country can also choose to refuse repayment and use the funds it owes to save against future macroeconomic shocks, earning interest until the shock occurs and the funds are needed. Thus, the country will be better off to default once it secures its maximum level of borrowing.2

Bulow and Rogoff (1989) consider an alternative to default and saving. The defaulting country might purchase insurance that pays when the country experiences future adverse macroeconomic events. Such an insurance contract would pay in those years in which production fell short. Therefore, Bulow and Rogoff contend, the country will also be better off if it defaults and purchases the macroeconomic insurance (or defaults and saves). As Bulow and Rogoff put the point, “Small countries will not meet loan obligations to maintain a reputation for repaying because, under fairly general conditions, it is impossible for them to have such a reputation” (p. 49). The purpose of Bulow and Rogoff’s argument is not to assert that reputation plays no role in understanding international lending to sovereigns, but to prove that reputation by itself is not adequate to explain the world of sovereign debt that we actually observe, especially if both the prospective borrower and the prospective lender have perfect information about the incentives of the other party. As a consequence, lending “must be supported by the direct sanctions available to creditors, and cannot be supported by a country’s ‘reputation for repayment’ ” (p. 43).

Other limitations with simple reputational explanations are also evident under real-world considerations. For example, early reputational explanations assumed that lenders acted monolithically, that if a sovereign defaulted aga...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Dedication
• Introduction
• Acknowledgments
• Part I: The Political Economy of Sovereign Debt
• Part II: Making Sovereign Debt Work
• Part III: Sovereign Defaults, Restructurings, and the Resumption of Borrowing
• Part IV: Legal and Contractual Dimensions of Restructurings and Defaults
• Part V: Historical Perspectives
• Part VI: Sovereign Debt in Emerging Markets
• Part VII: Sovereign Debt and Financial Crises
• Index