Rethinking Sovereign Debt

Politics, Reputation, and Legitimacy in Modern Finance

Odette Lienau

• Publisher: Harvard University Press
• Year: 2014
• Print ISBN: 9780674725065
• eBook ISBN: 9780674727649
• Topic: Economics
• Subtopic: International Business
• Index: Economics

Conventional wisdom holds that all nations must repay debt. Regardless of the legitimacy of the regime that signs the contract, a country that fails to honor its loan obligations damages its reputation, inviting still greater problems down the road. Yet difficult dilemmas arise from this assumption. Should today's South Africa be responsible for apartheid-era debt? Is it reasonable to tether postwar Iraq with Saddam Hussein's excesses?

Rethinking Sovereign Debt is a probing historical analysis of how sovereign debt continuity--the rule that nations should repay loans even after a major regime change, or expect reputational consequences--became the consensus approach. Odette Lienau contends that the practice is not essential for functioning international capital markets, and demonstrates how it relies on ideas of absolutist government that have come under fire over the last century. Challenging previous accounts, Lienau incorporates a wealth of original research to argue that Soviet Russia's repudiation of Tsarist debt and Great Britain's 1923 arbitration with Costa Rica hint at the feasibility of selective debt cancellation. She traces the notion of debt continuity from the post-World War I era to the present, emphasizing the role of government officials, the World Bank, and private-market actors in shaping our existing framework.

Lienau calls on scholars and policymakers to recognize political choice and historical precedent in sovereign debt and reputation, in order to move beyond an impasse when a government is overthrown.

1

Open Questions in Sovereign Debt

SOVEREIGN DEBT markets have demonstrated incredible resilience despite a century of dramatic political and economic upheaval. Among the most remarkable aspects of the contemporary debt regime is the degree to which expectations of borrowers remain relatively uniform even in the face of such major shifts. These basic expectations resolve into one background rule: sovereign borrowers must repay, regardless of the circumstances of the initial debt contract, the actual use of loan proceeds, or the exigencies of any potential default. This is not to say that countries always pay; certainly, they do not. But the background rule remains, and it sets the standard by which creditors and others form their reputational judgments and against which sovereign borrowers are evaluated and chastised.

This repayment norm helps to immunize the debt regime from serious challenge and to stabilize the massive sums at stake. In particular, it buttresses our avoidance of prickly questions about fairness and appropriateness in the international economic arena. Several troubling queries in recent decades include: Should a black-African-led South Africa really be expected to repay apartheid era debt? Or, given that Saddam Hussein was a dictator who used funds for the oppression of a majority of Iraq’s population, would it be appropriate to require future Iraqi generations to pay for his iniquity? More generally, who counts as the “sovereign” in these debt situations—is sovereignty just the legal shell for whoever happens to control a territory, or does it imply underlying principles of legitimate representation or public benefit? And how might all this fit into assessments of a country’s creditworthiness?

Notwithstanding such questions, the repayment norm exerts a particular kind of power in international economic relations by shaping expectations of appropriate action in the area of sovereign debt. The rule is strengthened by its popular identity as a market principle, with effects that can be identified and measured but that ultimately cannot be changed. A study commissioned by the United Nations Conference on Trade and Development (UNCTAD) noted,

one of the major policy concerns that has deterred some transitional regimes from repudiating “odious” debt from the previous regime is that of reputation in the capital markets; a transitional regime may be concerned that creditors will not in the future provide access to funds, because they are unable to distinguish the exceptional political decision to repudiate debt due to its odiousness from the general creditworthiness of the regime.¹

The narrative shaping such decisions suggests that without the background rule of consistent repayment, reinforced by the disciplining mechanism of reputation, lending to many sovereign states would disappear. International debt markets in the absence of a clear cross-border enforcement mechanism would be too risky, requiring more information on sovereign borrowers’ subjective repayment proclivities than would be worthwhile for any creditor to collect. Although the repayment norm is most starkly applied in situations of regime change and transitional justice, its expectations filter into the prospects and bargaining positions of debt negotiations more generally. If repayment is expected even in such extreme circumstances, then debtors should certainly bear the burden in other situations that might emerge. By policing the boundaries of the sovereign debt regime—and ensuring that such issues remain marginal—this rule keeps the core flow of capital safe and relatively free of controversy.

In this volume, I argue that the market narrative supporting the repayment norm is overly simplistic and in some respects entirely wrong. It forgets to ask key questions about the relationship between sovereign debt, reputation, and legitimacy over the last century—questions that have surprising answers embedded in the historical development of modern finance, with significant ramifications for how we approach debt markets in the future. How have we come to think that the norm of sovereign debt continuity—the rule that sovereign states should repay debt even after a major regime change and the related expectation that they will otherwise suffer reputational consequences—is more or less unavoidable for a working international financial system? Is it possible to think of an alternative approach—or find one historically—in which odious debt ideas and selective debt cancellation might be incorporated into a functioning debt market grounded in reputational assessments? And if so, why hasn’t such a system developed, especially given the politicized discussions of sovereign legitimacy that have taken place alongside the development of modern finance?

The framing of repayment and reputation as a market principle—one that disciplines debtors and creditors alike—discourages this type of questioning in part by propagating the following three assumptions. First, although creditors may assess a specific borrower’s political characteristics through the lens of sovereign risk, judgments about a borrower’s repayment decisions are not shaped by politics per se. Rather, they are simply the best objective assessment of a given set of material facts. Second, the mechanism of sovereign reputation itself is similarly free from subjective and historically variable political judgments. And third, all rational creditors are expected to respond in basically the same way to particular market events—especially those events that challenge the principle of continuous repayment. Therefore, it is not necessary to study the historically conditioned identities and interests of particular creditors to understand how capital markets, as a whole, will respond to any given sovereign action. These assumptions of political neutrality, reputational stability, and creditor uniformity support an assessment that the basic contours of the sovereign debt regime are effectively unchangeable.

In the following pages, I contend that, far from being the stable and all but inevitable market principle we sometimes imagine, the debt continuity norm is intrinsically political and historically variable. It has been shaped over the last century by political actors, broader ideological shifts, and changing public and private creditor structures. To begin with, any discussion of sovereign debt is rendered intelligible only by quietly incorporating a definition of “sovereignty” that is necessarily normative. Depending on the theory of sovereignty implicitly or explicitly adopted in international economic relations at any given time, the practices of sovereign debt and reputation may diverge significantly. Furthermore, creditor uniformity cannot simply be assumed, and in fact different creditors may interpret—and historically have interpreted—the same politicized debt repudiation in opposing ways. A close look at the post-World War I cases of the Soviet Union and Costa Rica suggests how, under conditions of market competition and ideological flexibility, creditors can make rational reputational judgments in favor of post-repudiation lending. The absence of similar cases later in the century resulted not from rigid market certainties but instead from changes in creditor interactions and broader norms of sovereignty. These shifts in turn followed from choices by actors such as the World Bank, globalizing private banks, and the US government.

What might this theoretical instability and historical variability mean for the repayment norm today? A strict rule of sovereign debt continuity after regime change is hardly necessary for workable reputational assessments in international capital markets. Alternative approaches, incorporating ideas of illegitimate debt and allowing for limited cancellation, emerged historically and could function more fully in the future. Thus scholarly and popular discussions of sovereign debt have the potential to be much more wide-ranging than their current contours imply. That said, the norm is deeply embedded in international finance and can’t simply be argued away, and it is more powerful than much conventionally enforceable treaty law at shaping international actions. Indeed, on difficult issues like debt repayment after regime change and potentially illegitimate debt there is no multilateral treaty in force, even despite several efforts. Legal scholars and activists have attempted to resuscitate ideas such as a formal doctrine of “odious debt,” according to which a fallen regime’s debt need not be repaid if it was not authorized by and did not benefit the underlying population.² However, efforts to alter the repayment standards run up against already powerful practices of debt continuity—something of a global soft law in hiding—that have the predictability and compliance pull of conventional law if not its external trappings.

To think seriously about altering the current framework, then, it is necessary to recognize its theoretical supports and historical foundations. In this introductory chapter, I aim to lay the groundwork for such an understanding. I begin by filling out the analytical problems with the conventional approach to sovereign continuity in debt and reputation, and identify opposing “statist” and “non-statist” ways of thinking through the question. I then highlight how we can study both the historical variation in this norm and its political underpinnings through the issue of odious debt. This introduction also provides an overview of the historical arc of my argument, which underscores that other approaches to debt continuity emerged in the early twentieth century and suggests how they were covered over by broader political and financial trends in the latter part of the century. Finally, I discuss the role of power and interest in the long-term development of a norm that, over time, has exercised significant power in its own right.

Problems with the Conventional Wisdom

The assumptions of neutrality, reputational stability, and creditor uniformity that underpin the repayment norm are, if not entirely mistaken, at least greatly oversimplified. Although I expand on this claim more fully in chapter 2, a quick overview is warranted up front. To begin with, one of the most puzzling elements of the conventional narrative is the notion that the sovereign debt regime’s repayment rule could be apolitical. The mere mention of sovereign debt invokes one of the most politically controversial concepts in global affairs and international law: sovereignty. And perhaps unwittingly, a very distinct political theory of sovereignty supports the current system of international lending. In discussing arguments that the post-2003 Iraqi regime should be freed of Hussein-era debt, a Financial Times leader noted, “The principle [being attacked] is sovereign continuity—the idea that governments should honor debts contracted by predecessors. Without this, there would be no lending to governments.”³ Sovereign continuity means that the same “sovereign” remains, and thus is subject to the same contractual obligations, regardless of any internal political changes. It effectively derives from what I call throughout this book a strictly statist conception of sovereignty—the idea that the content of and changes in a state’s internal structure, interests, and popular support are irrelevant to its status as a legitimate sovereign and thus to its external relations and obligations. While this statist vision has deep roots in global affairs, it is heavily contested in legal and international relations theory, and indeed it has been subject to debate and alteration over the twentieth century and into the twenty-first. In particular, the possibilities of democratic sovereignty or a sovereignty legally bound by constitutional norms are some of the non-statist concepts of sovereignty that have gained considerable traction in the international arena. An international economic regime more attuned to these alternative, non-statist concepts should be much more hospitable to something like the odious debt idea mentioned above—and thus more amenable to noncontinuity and debt cancellation under certain circumstances. Indeed, I suggest that the necessity of a statist repayment rule for continued sovereign lending is a contestable claim. But what is perhaps most puzzling is the way in which, in the face of these multiple alternatives, a statist political theory has become so thoroughly embedded in the sovereign debt regime that its deeply political character effectively disappears.

Turning to reputation does not in and of itself provide a sufficient answer. Just as the rule of continuous repayment depends on a particular vision of legitimate sovereignty, the reputational mechanism supporting this rule takes the same implicit theoretical approach. The determination of which sovereign a reputational assessment attaches to is necessarily infused with a background, historically informed political judgment: Should a recently anointed democratic government, flush from the overthrow of a dictator, be assessed as a new, untested sovereign? Or is it evaluated as a continuation of the previous regime? The statist and non-statist approaches suggest very different responses. In short, the call for a reputational assessment does not on its own necessitate the adoption of a statist political theory. It is entirely possible to maintain the importance of reputational assessments in general while accepting that debt repudiation should not result in a lending hiatus in all cases. Far from leading in a mechanistic way to the repayment-as-market principle conclusion, reputational judgment itself is fairly flexible. This plasticity suggests that the category of “excusable default”—sovereign defaults justified by major events such as natural disasters and thus having only modest reputational repercussions—may be broad enough to include principled political defaults under certain circumstances.⁴ It also deepens the puzzle of how the very notion of a working reputational mechanism became so thoroughly intertwined with a statist insistence on debt continuity that the possibility of alternatives faded away.

Perhaps this all leads to the final key assumption of the market principle story—that rational creditors will respond in basically the same way to market events, and in particular will respond in the same hostile way to events that challenge the rule of continuous repayment.⁵ Certainly, the norm of sovereign continuity provides something of a windfall to creditors as a whole; it means that states will be expected to repay debt that might have been subject to cancellation under alternative sovereignty frameworks. But even accepting this windfall, what would account for the conceptual strength of a statist approach relative to all others? Part of what is interesting is the absence of any acknowledgment that non-statist concepts are entirely consistent with making reputational judgments. Is it possible that creditors coordinate to suppress the very idea that non-statist approaches are possible, including in academic and broader policy discussions of sovereign debt? This would be quite a feat of deliberate collusion—one for which there does not appear to be evidence, though such findings undoubtedly would be newsworthy. I find it more likely that contemporary creditors, and those that write about them, have been similarly conditioned to understand the rules of repayment and reputation according to a fairly narrow political theory.

But even the initial assumption of a shared creditor interest in universal repayment is problematic, and is not fully supported by the historical record. To begin with, it is not entirely clear that all creditors would oppose nonpayment in all instances. This could be the case if, for example, a creditor accepted as plausible the argument that a successor regime constituted a new sovereign, worthy of modest and appropriately priced investment, rather than an intransigent continuation of the previous regime. Such a stance would effectively indicate a reputational assessment consistent with a non-statist concept of sovereignty. While a creditor would hardly be keen to hear such an argument from its own debtor, it might be more receptive to such an argument from a new potential client, particularly in the context of a competitive market.

Furthermore, there are historical instances in which creditors respond in entirely different ways to the same debt repudiation. The Soviet repudiation of tsarist debt, perhaps the most notorious default of the twentieth century, is generally proffered as an exemplar of the reputational risk associated with repudiation, for example in Michael Tomz’s important work on reputation in sovereign debt markets.⁶ Read as such, it would support the repayment rule’s status as a uniform and historically stable market principle. However, as I argue in chapter 3, this reading, based principally on the fact that the new regime was unable to float bonds on the international capital markets, overlooks key elements of the historical record. In fact, while creditors of the previous tsarist regime remained very hostile and insistent on repayment, several newer American banks actually sought to facilitate long-term bond issues by the new Soviet government in the 1920s. These banks were halted not by a reputational assessment—indeed they were impressed by the Soviet Union’s reliable payment of shorter-term trade credits—but rather by the US government’s political hostility to the regime. A closer look at both the theory and history of creditor interaction thus demonstrates that the existence of a relatively uniform creditor approach to sovereign reputation cannot simply be assumed but has to be explained.

What does this mean for the solidity of the sovereign debt regime, including its bulwark rule of repayment and its coordinating reputational mechanism? It is true that settled expectations and market practices have developed, which shut off questions of sovereign legitimacy that might reasonably be at the center of international lending. An equilibrium of sorts has been reached, and any countervailing pressure has thus far been insufficient to produce a real shift. But this does not foreclose the possibility that there are several potentially stable market norms—or multiple equilibria—that could yet develop or that might have developed historically under different circumstances.⁷ The fact that the current system looks to ma...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Contents
• 1. Open Questions in Sovereign Debt
• 2. Theoretical Underpinnings of Modern Finance
• 3. Costly Talk? Reinterpreting the Soviet Repudiation
• 4. Costa Rica, Public Benefit, and the Rule of Law
• 5. Public and Private Capital in Mid-Century Repayment Norms
• 6. Continuity and Consolidation in the Return of Private Finance
• 7. Legitimacy and Debt at the Turn of the Century
• 8. Politics and Prospects
• Notes
• Acknowledgments
• Index