Revisiting Sovereign Bankruptcy

Philip’s posting last week of the new report from the Committee on International Economic Policy and Reform, Revisiting Sovereign Bankruptcy, attracted little comment.   This is a pity as it is an impressive piece of work – clear and well argued.   The focus of the report:

This year’s CIEPR report argues that both the nature and our understanding of sovereign debt problems have changed in ways that create a much stronger case for an orderly sovereign bankruptcy regime today than ten years ago. 

Some belated and slightly wonkish comments after the break. 

 A great strength of the report is that it deals head on with the classic trade off between ex post and ex ante inefficiency in thinking about the appropriate debt regime.   The ex post inefficiency focuses on the costs associated with more difficult restructuring, notably the “hold out” problem.   The classic ex ante inefficiency issue is the incentive – or dynamic commitment – problem associated time inconsistency of promises to repay.   The latter problem can severely limit ex ante borrowing capacity.   Of course, this incentive problem is not limited to sovereign debt.   Indeed, a major focus of modern corporate finance literature has been issue credit rationing, and how firms “bend over backwards” to convince lenders that they will repay ex post, often by ensuring that default is seen as sufficiently costly.  

The core argument of the report is that the balance of concern has shifted for the sovereign debt market, making the case for a sovereign restructuring regime stronger than in the past.   Three changes are highlighted: (1) the holdout problem has become more severe, with specific reference to the travails of Argentina in New York courts.   (2) A new ex ante efficiency issue has reared its head – the incentive to delay restructuring and do too little when it does happen.   And (3) the specific problems of the euro zone, where the fear of spillovers to other common currency members increases the reluctance to restructure.  

The analysis of all three issues is enlightening and I strongly recommend that anyone interested in these issues takes the time to read the report.   However, I want to raise two lingering concerns that I had with the analysis, and would very much welcomes peoples’ reactions. 

First, I think there is a danger of giving too much weight to the “too little-too late” problem.   There is a natural tendency to focus on cases where restructuring was excessively delayed/insufficient as revealed by subsequent events.   Greece is a dramatic case in point (see footnote 15, p. 11) – although in Greece’s case hindsight was not really required to see the mistake being made.   In fairness, the report does note that a combination of domestic adjustment and official support can work, with the example of Turkey being highlighted.   (See also the literature on catalytic finance, e.g., Morris and Shin.)    

It is also useful to consider the Irish case.   While the final chapters of Ireland’s crisis have yet to be written, it is easy to forget the clamour for an Irish default back in 2011.   The Prime Time programme on default is a useful reminder: see here.   Again, while Ireland is not out of the woods in terms of debt sustainability, the fall in the risk premium on Irish debt has been dramatic.   This appears to be an emerging success story of catalytic finance, with the combination of a demonstrated capacity to adjust along with strengthened conditional European support mechanisms – though arguably not strengthened enough – interacting positively to reduce default fears. 

Of course, your view on default depends significantly on your view on the costs of default.    The report recognises that default can be very costly (Chapter 2, p. 14).    Recent literature has tended to downplay reputational costs.   But there has been increased emphasis on output costs (see here).   The costs of default are likely to be quite country specific.   In Ireland’s case, one factor that should reduce the costs is the fact that a significant fraction of the debt is held by foreign investors.   On the other hand, the formal similarity between the dynamic commitment problem for debt and the “capital levy problem” – i.e. the ex post incentive to tax installed capital – raises concerns about spillover from sovereign debt default to foreign direct investment.   While reputational factors might limit the spillover, the importance of FDI to Ireland’s growth strategy should give pause.   

Second, although the report does highlight the risks of an overly rapid phase in of the proposed new arrangements for the euro zone – in particular, the risk of causing self fulfilling expectations of default – at times it seems overly relaxed about the risk.    This might be partly the result of having multiple authors that have understandably not quite converged.   For example, in a discussion of how to deal now with the legacy debt overhang in the euro zone, the final chapter (p. 43) suggests:

[A]ny ESM-sanctioned debt-restructuring programs as a condition of financial support could be limited to countries with debt above the long-run upper threshold. The result would be to limit the range within which debt restructurings can be expected. While this option would make debt restructuring easier by making life more difficult for holdouts, it would do little to make restructuring more likely. The dominant incentives for debtor and creditors countries in the euro area would still be to procrastinate and gamble for resurrection, at least until an effective and durable firewall for other countries and for banking systems is in place.  

For some countries, this would hardly give investors confidence given that it was previously suggested that this threshold should be set at 90 percent of GDP!

In any case, an extremely valuable contribution to the debate.

Comments

comments

16 thoughts on “Revisiting Sovereign Bankruptcy”

  1. I read it – it makes a lot of sense – if a little overdone on Greece. The 20% difference idir GDP % GNP useful for Hibernia – prob due to P. Lane being on the roster.

    Politics of course is another universe ….

  2. Not sure there was a clamour for default, in the sense of repudiation of national debt, in 2011 or other times. Repudiation of the wretched promissory notes, yes. And now they are actual national and therefore unrepudiatable debt. I find it hard to recall anyone saying walk from the stuff the NTMA issued. Anyhow, all moot now.

  3. Re holdouts is it not the case that most new em debt issuance has a clause stipulating that if a majority of debt holders , 67% iirc, agree to the restructure there can’t be any holdouts. It was in the FT a while ago.

  4. Moody’s said in 2010 that since 1997, there had been 20 sovereign defaults on government bonds. “Overall, 15% of defaults were due to banking crises, 15% to long-term economic stagnation, 35% to high debt burden, and 35% to political or institutional weaknesses.”

    Past defaulters had high foreign currency exposure, an average of 76% of total debt was in foreign currency in the year prior to default, and high debt servicing costs.

    The 20 sovereign defaults since 1997 were Mongolia, Venezuela, Russia, Ukraine, Pakistan, Ecuador (twice), Turkey, Ivory Coast, Argentina, Moldova, Paraguay, Uruguay, Domenica, Cameroon, Grenada, Dominican Republic, Belize, Seychelles and Jamaica.

    Those who were calling for an Irish default or partial default (those Anglo PNs were used to fund a depositor bailout – who should have funded that if at all?) were not to be found among indigenous businesses dependent on foreign supplies of raw materials or people dependent on subsistence payments.

    Argentina and Iceland were often cited – – both self-sufficient in staple food items!

  5. “In Ireland’s case, one factor that should reduce the costs is the fact that a significant fraction of the debt is held by foreign investors. ”
    In comparison too….?
    Argy case update,as a fascinating as aide they were represented in Delaware yesterday,IRBC US Ch 15 BK.
    http://www.bloomberg.com/news/2013-10-07/argentina-rejected-by-u-s-court-in-bond-payment-appeal.html
    http://www.reuters.com/article/2013/10/08/ireland-anglo-hedgefund-idUSL1N0HY2B720131008

  6. It seems the IMF are not buying the corner turning argument according to AEP..
    http://www.telegraph.co.uk/finance/financialcrisis/10365206/IMF-sours-on-BRICs-and-doubts-eurozone-recovery-claims.html

    A flavour..
    “Crucially, the Fund disputed claims by EU officials that Club Med states have cut labour costs and reduced current account deficits by enough to restore their economies to a viable footing within EMU.
    It said better appearances are largely an illusion of the cycle, and the result of crushing internal demand. “Current account deficits could widen again significantly when cyclical conditions improve,” it said.
    The harsh reality is that the net foreign positions of Greece, Ireland, Portugal, and Spain will still be minus 80pc of GDP near the end of the decade. The IMF said it will take years of hard grind to reverse all the damage, no easy task as “adjustment fatigue” sets in.”

    Cavaet emptor?

  7. “The IMF said it will take years of hard grind to reverse all the damage … …!

    Damage? Hard grind? Oh! dear! Damage to whom? And who be the grindors and who be the grinded?

    How do you ‘reverse’ the lives and welfare of millions of folk who have been ‘damaged’ as a result of policy actions which required either psychological and/or physical shocks to achieve the ideological outcomes? You do not!

  8. Great report. Well written on the whole and concrete. Not complete. But a significant contribution.
    Of course a move towards a legislative regime that creates better ex ante incentives for all parties involved is likely to contribute to greater economic welfare. Difficult to argue against that from a public interest point of view.
    I’d fear however that a “leave well enough alone” attitude, along with too many cooks looking after the broth, etc. will lead to too little progress, too late.
    .
    One of the items that is not addressed, unless I missed something: how to create an incentive for a sovereign, with its restructured debt almost fully owned abroad, and a close to zero primary budget deficit, from adopting a long term strategy to simply roll over its debt … indefinitely? How does that prospect impact incentives for other euro area sovereigns today?
    This is still an issue that is brushed under the carpet or forgotten about for now. A priori, I’d have thought that a zero primary budget deficit and little burden from current interest payments would create the right conditions for strong growth in Greece. But the medicine is not working, probably in part because of the hit to confidence and reputational costs.
    That will be of interest to Ireland and Portugal et al, and is food for thought in relation to long term game plans.
    .
    While the CIEP makes the case for much more robust sovereign restructuring regimes, it doesn’t cover the extraordinarily challenging long term structural headwinds faced by some of the richest Western sovereigns (with e.g. S&P still projecting monstrously high debt / GDP levels on the basis of demographics alone, if not enough is done).
    Those risks have led the IMF and even the BIS to issue veiled warnings and seek longer term macro solutions, hinted at in their recent publications.
    The IMF’s chief economist Mr Blanchard, has been more explicit, if still guarded when he spoke at TCD’s Phil some two years ago, if I remember right.
    Chief among these solutions of course is more inflation. Not flavour of the day just now with central banks. But then they wouldn’t want to trumpet a long term change of policy in any case.
    These warnings are all likely to be repeated with a tad more openness in the upcoming IMF Fiscal Monitor and Global Financial Stability Report.

  9. @Brian Woods Snr

    Damage? Hard grind? Oh! dear! Damage to whom? And who be the grindors and who be the grinded?

    I have prepared a helpful neoliberal to English phrasebook.

    * Repair the damage: Implement state/social safety net shrinking policies we have always been in favour of.
    * Hard choices: Decisions that the general population would never support.
    * Painful reforms: Austerity policies intended to lead to a neoliberal social and political order.
    * Long painful grind: No benefit for the general population in any meaningful timeframe.
    * European partners: Germany.
    * Ireland: The branch of the EPP in power in Ireland.
    * Political realities: Germany really wants to pay as little as it can towards the costs of the banking crisis in the Eurozone.
    * The ECB: The idiot cop to the Bundesbank’s insane cop. Together, they fight employment.

    As an example:

    European neoliberal orthodoxese: “The political reality is that Ireland, in conjunction with its European partners, has had to take the difficult choice to implement painful reforms and focus on the long hard grind of repairing the damage to the economy.”

    means

    English: “Under pressure from Germany the Irish EPP administration is taking decisions that lack democratic legitimacy to shrink the state with no benefit for the country’s people in any meaningful timeframe so that the European Union can be one big unhappy neoliberal experiment and Germany can mimimize its losses from the European component of the global financial crisis.”

  10. To be fair to John’s memory of 2011, I at least argued fairly vigorously in favour of default back then. My view is no different in retrospect. I expected that without default we would bump along the bottom with an eventual slow crawling improvement in employment, and continuing weak growth. That is exactly what we have seen so far. (I discount much of the headline improvement in employment statistics as reflecting folks retreating into informal employment on the family farm when there is no longer a place for them in monetary economy. Agriculture aside, total employment in Ireland is roughly where it was in 2011.)

    The long term costs of default are likely related to the degree to which the default is perceived as voluntary. If we were to default now, it would be seen as highly voluntary, and almost certain to have a long term impact. Back in 2011 or earlier, we could have ridden the crisis towards default by taking a hard line with the EU elements of the Troika, and portrayed the outcome as an involuntary consequence of the playing out of domestic and EU politics.

    The inevitable crunch on government finances required to bring the positive primary balance forward could have been used towards engineering a greater improvement in cost competitiveness than we have seen, improving propspects for growth.

    I still think it was a fundamental error not to do this while we had the opportunity. Debt service and repayments will unnecessarily pull money out of the economy for decades to come, dragging on domestic economic activity, and harming the competitiveness of exporters whose costs are inflated by the extraction of taxes for these purposes.

    However, other crises may come along, renewing the opportunity. The US debt ceiling crisis may explode. Any of a number of Southern European countries with growth prospects even worse than ours may finally draw logical conclusions on their debt commitments and participation in the euro. We should be ready to take advantage.

  11. These guys are morons

    Mein Führer, Jon Nadler and Paul Krugman have been overworked

    People read them to laugh

    The great Keynesians experiment is coming to an end

  12. @ Shay: Much obliged for the transmutation.

    But why us? 4 and bit mill folk on a draughty island in the Atlantic. Can we be that crucial? Seems weird somehow. Now if it were ES or IT. Ah! Maybe they be of a riotous disposition. Tanks would be needed. But us sheep? A barking lapdog should suffice. Whose the mutt then? They dip sheep, don’t they?

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