Sovereign Debt Crises and Negotiations in Brazil and Mexico, 1888-1914

Governments versus Bankers

Leonardo Weller

• Publisher: Palgrave Macmillan
• Year: 2018
• Print ISBN:
  9783319736327
• eBook ISBN:
  9783319736334
• Topic: Economics
• Subtopic: Financial Services
• Index: Economics

Addresses the pre-1914 sovereign debt market from both creditors' and borrowing governments' perspectives

Presents new primary documents that bolster opinions of Brazil and Mexican government negotiation effectiveness

Proposes a new analytical framework to conceptualize how factors determined the relative power between governments and creditors

Part IGovernments versus Bankers

© The Author(s) 2018

Leonardo WellerSovereign Debt Crises and Negotiations in Brazil and Mexico, 1888-1914https://doi.org/10.1007/978-3-319-73633-4_1

Begin Abstract

1. Introduction

Leonardo Weller¹

(1)

São Paulo School of Economics—FGV, São Paulo, Brazil

Leonardo Weller

Email: [email protected]

End Abstract

The relations between governments and banks were at the very core of the sovereign debt market during the first financial globalisation, which lasted from the 1870s to the outbreak of the First World War. The banks in change of underwriting sovereign debt—obligations owned by central governments and denominated in foreign currency—arranged the issuing of bonds in international markets and the transfer of resources between borrowing governments and final creditors. The public associated governments with the banks in charge of underwriting their debt. As a consequence, defaults penalised both governments and banks: They restricted the formers’ credit and downgraded the latters’ status in the highly hierarchical debt underwriting business. Governments either negotiated loans with different banks or granted a monopoly on their debt—a decision that implied different payoffs. Negotiation reduced borrowing costs, while patron banking could improve the government’s status, generate business opportunities and create a credit umbrella during crises.

By addressing the contrasting and complementary cases of Brazil and Mexico, this book demonstrates that governments adopted different approaches when dealing with the underwriters of their debt. Brazilian high officials handed a monopoly to the London Rothschilds, whereas the Mexicans did not accept patron-banking and negotiated cheap loans with many underwriters. This book assesses why these governments decided to relate to banks in such opposing ways.

This introductory chapter provides an overview of the interaction between governments and banks before 1914. The first section explains the role of underwriters, and the second describes two major changes that transformed the market around the turn of the twentieth century. On the one hand, banks from continental Europe and the USA contested the dominant position that British underwriters had acquired since the market began in the 1820s. On the other hand, an information revolution enabled final bondholders to operate in a more independent way than in the 1820s, when they relied on banks to decide which bonds to buy. Together, these transformations increased the power of governments to foster competition among banks when negotiating borrowing terms. The remainder of this chapter outlines the book and previews the Brazilian and Mexican cases.

Governments and Banks in the First Financial Globalisation

The banks in charge of underwriting sovereign debt played a more important role in the past than today. In recent times, borrowing governments sell their bonds almost directly to a multitude of lenders who operate mostly online. Banks still underwrite bonds, participating in the issuing of new debt and the repayment of old obligations. However, as a general rule, the underwriting business does not involve much more than the transfer of resources from one side to another, charging relatively small fees for that service.

Banks played a crucial role in the pre-1914 sovereign debt market. The act of underwriting loans included some rather detailed tasks. Banks physically printed the bonds and organised their sale. They published announcements and news in the specialised press to attract final creditors, who bought and held the bonds. Banks collected periodical coupons, which the bondholders detached from the bonds and exchanged for interest payments. They also intermediated the payment of the debt’s principal, helping the governments to buy back bonds as they reached maturity.

Technology partially explains why the process of debt underwriting was much more laborious in the past. The bonds were large pieces of paper and the handling of payments needed to be carried out in loco. Governments hired banks with branches in the cities that hosted international debt markets. It was common for a single loan to involve a group of underwriters—a syndicate—based in different places such as London, Paris, Brussels, Berlin and New York.

In the past, most contracts allowed the underwriters to buy the bonds from the government on the primary market and subsequently sell them at a different price on the secondary market. Contemporaries referred to such operations as taken under firm commitment. In some cases, the underwriters held the bonds for several months, expecting that improved market conditions would raise their price. With some luck (or inside information), bankers could realise some handsome profit from price run-ups.

Yet the business of debt underwriting differed from today in a more profound way than the simple act of issuing bonds and managing payments. The most important difference is that, in the past, the public identified the banks with the debt they underwrote and, more broadly, the governments that issued it. Today a Greek bond underwritten by Goldman Sachs is overall Greece’s business. If the government in Athens defaults, it will face problems to borrow again—which, in some sense, has happened. Goldman Sachs would likely choose not to hold Greek debt, but the default would not disrupt the bank’s activities.

That was less the case in the past. The banks of the first financial globalisation did not guarantee the debt they underwrote, but they did endorse it. The names of underwriters were printed on bonds. The Investor’s Monthly Manual, the official publication of the London Stock Exchange, listed the debt issues traded on that market and reported their respective underwriters. In an article entitled “Bonds and Brands,” Flandreau and Flores (2009) assert that, whenever they decided to underwrite the debt of a given country, high-class banks such as the London House of Rothschild (hereafter Rothschilds) sent signals to the public that operated on the secondary market. The Rothschilds “brand” indicated that associated governments were creditworthy. Second-class banks underwrote the debt of less credible borrowers; the good ones had been taken by premier underwriters. This hierarchical system among banks created a hierarchy of governments that determined the preferences of bondholders. According to this view, the underwriters were “gate keepers” that separated the worthy from the risky sovereign debt.¹

It is possible to draw a parallel between the role of underwriters before 1914 and of credit agencies today. The credit rating business started when John Moody attributed rates to American railways’ debt in 1908. Moody expanded its business to sovereign debt in 1918; Standard and Poor’s and Fitch followed suit. Coincidence or not, the credit rating market begun just after the Soviets repudiated the Russian debt. The 1917 moratorium ruined Rothschilds’ default-free brand forever—the old Russian Empire was Rothschilds’ largest client. There is one significant difference between both activities, however: Underwriters used to face substantial losses when their clients defaulted, while credit agencies are not badly hurt when they get it wrong—they have done so greatly and are still in business. In this sense, traditional debt underwriting involved less conflict of interest than the business performed by credit agencies.²

Governments benefited from the association with premier banks. Brazil’s bonds were attractive not only because of the country’s capacity to meet payments but also due to Rothschilds’ brand. Other countries did not have access to high-class banks because o...

Table of contents

• Cover
• Front Matter
• Part I. Governments versus Bankers
• Part II. Brazil versus Rothschilds
• Part III. Mexico versus Mediocre Banks
• Back Matter