Understanding Sovereign Debt and Default

Q. What role does political “impatience” play, in countries large and small, when taking on additional sovereign debt?

A. There are a couple of reasons countries might want to take on a lot of debt. One is that they are capital scarce. They have lots of projects they would like to finance.

…If I look at countries that borrow a lot, over the last 30 years, usually they didn’t do great. They didn’t appear to invest in things that provided high returns later. Accounts in Swiss banks, not things that were in the interests of their citizens.

The other possibility is that a patient government would have reason to borrow to deal with shocks that are temporary, like a hurricane or an earthquake. It’s not really about long-term growth, it’s about smoothing the shocks. Repairing roads, bridges and the like. The expectation is that you’ll repay when things are good.

But there’s a lot of evidence that emerging markets are “pro-cyclical.” They borrow more in good times, rather than the other way around. Then they have trouble repaying in bad times.

The final alternative is that they are borrowing because their governments are impatient.

Q. Academic work suggests many less-developed countries are willing to grab 65 cents today rather than wait for a dollar in the future.

A. In a developed country, think about how much consumption people are giving up today for consumption in the next year. One way to get at that is to look at the interest rate. Take the U.S. T-bill rate. It’s averaging 2 percent. Ignoring inflation, that means a U.S. household that invests saving in T-bills is willing to give up 100 units of consumption today for 102 units of consumption next year. That would be a great deal for the borrower.

But emerging markets will take worse deals.

Q. Like interest rates of 35 percent? Which would give them 65 cents that they’d have to repay with a dollar in the future.

A. Exactly. They would be taking a much bigger gamble. The additional cost of borrowing is the possibility of default coming down the line. [Lenders won’t offer loans without a big interest rate premium.] The cost of borrowing isn’t just prevailing interest rates. It’s the potential for default. In some state in the future you may not be able to pay back. Then you’ll lose your reputation [as a reliable borrower] for a decade – or more. It’s a gamble. They may be taking risks that are unnecessary. By borrowing, you leave yourself open to a mess, to a crisis.

Q. Access to international credit markets can be a curse, not a blessing?

A. It is reasonable to conceive that citizens of many of these countries would be better off if the country was unable to borrow externally. Ever.

Governments obviously don’t like this idea. They do want to borrow. They could stop themselves but they don’t. It’s a very resilient market. [Lending to sovereign nations] has been going on for more than 150 years. Countries have defaulted, a bunch of times, but they eventually regain access. Then they borrow again and default again. We [banks, private investors and governments] are willing to lend to them.

Q. How about an example of a major country that’s been irresponsible? After the 2004 Olympics, Greece was a basket case. They spent a fortune on a party.

A. And they lied about it, too.

So why should you care? None of your friends live there. You don’t buy things from there. You don’t invest there.

But you have to be careful. When Argentina defaulted in the early 2000s, I had a friend from graduate school, who was Italian, he was worried about it. His grandmother’s pension fund had invested in Argentinian bonds.

Also, financial problems can come along unexpectedly. A few years before, Greece was not seen as a problem. We talk about financial systems being fragile and subjects to runs [panics where investors demand their money immediately.] When Greece goes under, maybe other countries are vulnerable. It’s all connected.

The average person [in America] who doesn’t care about less-developed countries should think about the implications for developed countries, too.

Q. Examples of enlightened self-interest on the part of industrial countries?

A. Mexico had a big debt crisis in the early 1980s. Its effects lasted 10 years. Then, in the 1990s, things were looking up. In 1994, they had what we think was a liquidity crisis. Debt was coming due and they couldn’t roll it over. They had a huge amount of debt in very short-term bonds.

At the time, a U.S.-driven group provided a credit line to Mexico. It was possible that this was a problem that could go away if they had enough funds just to survive for a while. But if they default it would become a much bigger deal. If you care about migration, you may want your southern neighbors to be doing well. Also for economic reasons – you can trade. Mexico repaid the loans ahead of time.

Q. In a recent lecture, you identified three countries that defaulted on their government debts in the distant past: Russia, after its revolution; China, after its revolution; and your native country, Cuba, after the rise of Castro. Are out-and-out defaults really that rare? If so, why?

A. I think because there’s always an interest in maintaining some access to markets. [The exception: Communist revolutionaries, making a statement by cutting their nations off from capitalists.] Also, there is evidence that the market treats you badly if you really treat them badly. There’s something called “the haircut” imposed on foreigners that measures how much investors lose of what they lend?

Q. Like getting repaid 80 cents on the dollar?

A. You can get all the way down to zero. That number always varies a lot. You can divide defaults into two groups. Countries that treat their creditors really badly, that give them a really high “haircut.” …While if you look at countries that treated their creditors a bit better, their crisis were not as bad. They were able to regain entry quickly. Argentina is an example were creditors got very little. Uruguay and the Dominican Republican in early 2000s treated creditors better. It varies quite a bit.

Q. Why do creditors come back and lend again after a period of time, say 10 years? Is it because they’re bribed by borrowers paying incredibly high interest rates?

A. Yes. They get big returns, but it remains a risky investment.

Q. In 1998, Russia devalued the ruble and defaulted on much of its debt. The episode stoked fear in world financial markets. Falling oil prices and international economic sanctions led Russia to repeat that dance on the abyss from 2014-2017. How contagious are debt crises?

A. There’s evidence that one event in one place affects multiple places, too. We see default events seem to happen at the same time for many countries. Like in the 1980s, when a bunch of Latin American countries defaulted. When you plot these defaults, they seem to spike together as “events.” The effects happen across borders, between countries that don’t necessarily have a strong connection with each other.

Q. What shows the connections?

A. The interest rates countries pay are related to each other. It’s the risk premium being charged to a country. Comparing them indicates a risk premium in one country – pricing the chance of a default on government bonds – is related to the risk in another country.

Why is that? One possibility is the risk of contagion. For example, in 1998, the craziness in the Russia fed back into the financial markets in the U.S. That can affect other countries that rely on the U.S., too. Investors become afraid. Countries that are unrelated suddenly can be perceived as similarly risky. That makes high debts unsustainable. They could have been paid back at regular rates but can’t be paid at higher rates.

Another possibility to explain contagion is that a lot of this debt is being held by similar agents, basically investors in developed countries that are taking this risk. Things that affect them affect everybody.

Q. How does this all play out?

A. A country may say, “I could repay a loan at 2 percent but not 20 percent interest.” [At 20 percent interest], It defaults. Then the risk of future defaults justifies charging 20 percent interest. Access to credit can become fragile.

That’s the possibility of self-fulfilling prophecy, where belief changes behavior [that justify the changes in beliefs]. When Spain and Italy were in trouble, the ECB (European Central Bank) announced plans to buy bonds (of those distressed nations) in secondary markets. Buying without limits. The ECB’s president said they would do whatever it takes to “save the Euro.”

Very quickly after that, [interest rates for distressed European nations] went down. The ECB didn’t have to buy anything. It was just an announcement.

The example is suggestive but not conclusive. The ECB could still today be making a promise of bailing out these countries if things go really bad. At which point, they’d have to buy the bonds and face a loss in case of a default. There still is a case to be made that this is not without a cost.