Sovereign Debt, Debt Crisis, and Debt Resolution

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Sovereign Debt, Debt Crisis,and Debt Resolution

• Piroska M. Nagy
• EBRD
• VIII Summer School of the
• University of the Basque Country (UPV), San
  Sebastián, Spain
• July 26-30, 2004

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Presentation Overview

• Historic Overview of Sovereign Debt and Default
• Why Sovereign Debt Exists?
• Reasons for Debt Crisis
• Debt Resolutions, including HIPC
• Hot Issues Today

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Section One

• Historical overview
• Why Sovereign Debt Exists?
• Reasons for Debt Crisis
• Debt Resolutions, including HIPC
• Hot Issues Today

Historic Overview
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Public (sovereign) debt is quite high and rising
in emerging market economies
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Is this a new phenomenon? a historic overview

• Sovereign debt is as old as sovereigns
  themselves, and sovereign default exists since
  sovereign debt exists. First recorded sovereign
  debt default goes back to the fourth century BC,
  when 10 out of 13 Greek municipalities defaulted
  on loans to the Delos temple
• Most early defaults were resolved through
  currency debasement, ie., inflation/devaluation.
  Debt restructuring in earnest started only in the
  19th century

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Historic overview

• Hundreds of defaults since the beginning of the
  19th century, linked to 2 types of events
• Political-social upheaval, eg, WW I Turkey,
  Austria-Hungary, Bulgaria WW II Italy, Turkey,
  Japan Comminist takeover Russia (1917) China
  (1949) Czechslovakia (1952), Cuba (1960). I
  interestingly, this is the less typical reason.
• Most defaults have related to boom-bust cycles in
  international capital flows

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Historic overview

• According to Suter, Linder, and Morton, since
  early 1800s, there have been 7 lending booms
  with capital inflows
• The 1820-30s new Latin America, and US, Spain
  and Portugal
• 1860-70s LatAm, Us, Europe, Ottoman Empire,
  Egypt
• 1880s US, Australia, LatAm
• Before WW I Canada, Australia, Russia, some
  LatAm, Ottoman Empire, Bulgaria
• 1920s Germany, Japan, Canada, some LatAm
• 1970s LatAm, Spain, Yugoslavia, Romania, Poland,
  Africa
• 1990s LatAm, Asia, former Communist countries in
  Europe

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and these can be associated with 7 waves of
sovereign defaults
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Historic overview

• All lending booms ended in bust, in which some
  countries defaulted or rescheduled their debt. 3
  main triggers
• TOT deterioration
• Shock in creditor country recession, interest
  rate rise
• Shock in debtor countries
• Lending booms were financed in large part by
  capital inflows
• 19th century UK, France
• Early 20th century UK, France, Germany, the
  Netherlands, and US
• Interwar period UK and US
• Second half of 20th century US, Western Europe,
  Japan

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Emerging historical facts

• Latin America is a serial defaulter
• Some countries never defaulted (US, Canada,
  Australia, SA) few Asian or Arab countries have
• Some countries graduate Western Europe,
  Colombia since the 1930s
• The last boom-bust (1996-2003)resulted in
  historically very few defaults
• Many could not have access after the 1980s
• Much higher share of private borrowing during
  boom (resulting in non-not sovereign debt) Asia
• IMF played a much stronger role in prevention
  with large packages (Mexico, Brazil, Turkey)

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Section Two

• Historic Overview
• Reasons for Debt Crisis
• Debt Resolutions, including HPIC
• Hot Issues Today

Why Sovereign Debt Exists?
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Why sovereign debt exist?

• There are many defaults, and creditors have no
  direct control over/cannot liquidate the
  sovereign debtors assets. So why does the
  private sector lend to sovereigns at all?
• Three reasons
• It is probably not bad business over the long
  term (good and bad times taken together)
• There is some enforcement mechanism
• Exit illusion by individual market participants

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Why Sovereign Debt Exist?

• 1. Not bad business over the long term for
  creditors (necessarily difficult calculation)
• Contrary to belief, creditors not harmed most
  of the time. Studies consistently indicate that
  the long-term premium of EM debt relative to
  sovereign debt in the creditors country is small
  but positive. In the more recent period (late
  90s), except for Argentina, investor returns have
  been very high owing to high risk premia in good
  times

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Why Sovereign Debt Exist?

• 2. There is some enforcement/incentive
  mechanism fear of difficult return to markets
  worries about other sovereigns retaliation
  (trade or else) reputational risks
• 3. Exit illusion of market participants of not
  being the last remaining standing.

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Section Three

• Historic Overview
• Why Sovereign Debt Exists?
• Reasons for Sovereign Debt Crises
• Debt Resolutions, including HIPC
• Hot Issues Today

Reasons for Sovereign Debt Crisis
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Causes of EM debt crisis

• EM debt structure is biased towards short term,
  forex dominated debt (original sin, etc) both
  dangerous. Revenue base is weaker than in
  Advanced economies. Results are
• less debt tolerance
• more vulnerability
• Debt runs liquidity crisis triggered by
  self-fulfilling runs on debt

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Causes of EM debt crisis
EM debt crisis is often a currency crisis -
self-fulfilling dynamics

• Default reduces output, leading to currency
  depreciation
• Depreciation leads to default on foreign debt and
  inflation. (May also lead to private sector
  insolvency as well as banking sector crisis)
• This leads to currency crisis, which in turn
  induces government and possibly private sector
  insolvency

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Causes of EM debt crisis

• Incentives to over-borrow
• International moral hazard problem (countries
  expect to be bailed out by IFIs). Note Argentina
  has proven that such moral hazard arguments were
  exaggerated
• Domestic moral hazard Perottis middle class tax
  payer finances eventually the excessive spending
  plans of rich/poor, financed by foreign borrowing
• Triggers of domestic or external shocks (see
  earlier historic overview)

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What Governments Do When Faced with High Debt?

• In principle, 5 ways out
• Adjust fiscal policy to run primary surpluses
  (preferably via expenditure cuts) that allow for
  debt reduction
• Grow it out
• Inflate it away
• Sell assets
• Default

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What Governments Do When Faced with High Debt?

• The IMF (2003) looked at the largest debt-stock
  reduction episodes in 1970-2002 to see what
  governments have actually done
• 65 Default
• Non-defaulters a combination of high growth and
  primary surplus owing to expenditure reduction as
  well as exchange rate appreciation reducing
  forex-denominated debt (impact of transition
  economies)

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Section Four

• Historic Overview
• Why Sovereign Debt Exists?
• Reasons for Sovereign Debt Crises
• Debt Resolutions
• Hot Issues Today

Debt Resolutions, including HIPC
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Debt Resolution

• Negotiation process creditor coordination
• Terms of settlement
• Involvement of any official party (government,
  IMF)

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Debt Resolution - Creditor coordination

• Creditor coordination
• Early era ad hoc
• New era marked by establishment of the British
  Corporation of Foreign Bondholders (CFB) (1868 to
  the 1950s), the most successful creditor
  association ever.
• Represented the entire British financial sector
  bondholders.
• Formal structure (secretariat etc)
• Mandate twofold information on debtor and
  creditor coordination at negotiation and
  settlement.
• Structure reflected concentrated creditor group
  rel. few bondholders in 5-6 countries
• Enforcement no access to London market
• Excellent record

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Debt Resolution Creditor Coordination

• 1970-80s New market structure with loans by few
  hundred commercial banks. New institution Bank
  Advisory Committee (e.g. London Club),
  consisting of 10-15 key banks, representing
  hundreds of creditors.
• 1998-2003 resembling the early era of ad hoc
  approach, with no formal representation of large
  number of bondholders (except in Argentina with
  delay January 2004)
• Note a new debtor dominance approach
  take-it-or-leave-it offer to exchange existing
  bonds for new ones with lower NPV. Key (i)
  design an attractive enough offer to enlist wide
  participation in view of alternatives (ii)
  usually contingent on acceptance by majority
  (80-90).

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Debt Resolution Terms of Agreement

• First bond era 1800 1960s a mixture of five
  elements
• Capitalization of interest
• Moratorium on payment or maturity extension
• In some cases write-off of interest or even debt
• In some cases new loans for continued interest
  payments
• Debt-equity swaps (land, rail road) or mortgaging
  customs revenues

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Debt Resolution Terms of Agreement

• 1970s-80s trying to prevent outright default via
  negotiations before
• First trying to using full refinancing (1970s),
  then mix of refinancing and rescheduling of
  principal (Poland 1982, Mexico 1984)
• MYRAS (multi-year rescheduling)
• Brady Plan Significant NPV reduction with
  official enhancements, on the basis of a menu
  (choice among par bonds, discount bonds,
  debt-equity swaps, cash buy-backs)

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Debt Resolution Terms of Agreement

• 1998-2004 reduced-form Brady Plan
• Menu options, although mostly reduced to 2
  choices
• No debt-equity conversion
• Significant NPV reduction
• Argentina an exception
• - largest haircut ever (65)
• - without IFI participation
• - largest non-acceptance (to date) 24
• - one of the longest period until offer was
  made

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Debt Resolution Role of Official Sector
(Government, IFIs)

• Before WW II arms-length approach by governments
  (some pressure)
• After WW II increased official intervention via
• direct government involvement (US Treasury- Brady
  Plan 1989, 1994 Mexico Bank of England Zaire
  1976)
• IFI IMF direct involvement critical in the
  1980s, but more hands-off in 1998-2004, with now
  lending into arrears.

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HIPC as Debt Resolution Instrument

• Objective Reduce debt overhang and earmark
  freed-up resources for poverty reduction in the
  poorest countries (per capita lt US800)
• Special debt structure Most debt to official
  creditors (over 90), chiefly to IFIs / World
  Bank (more than half)
• In principle, mandatory for official creditors
  (most of the time) and persuasion for private
  ones

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HIPC as Debt Resolution Instrument

• Record 1996 2005
• US 32 billion debt relief committed in 2004 NPV
  terms. Total cost for all eligible countries
  US58 billion
• 27 beneficiary countries of which 18 permanent
  reduction.
• Drop in debt stock and debt service almost halved
  
• Increased poverty-reduction spending from 6½ of
  GDP in 1999 to 8 in 2004, with some increase in
  transparency
• More local ownership and domestic control
• Good initial market reaction (rating agencies
  not default but voluntary debt restructuring)

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HIPC as Debt Resolution Instrument

• Problems
• Underfinanced
• Millennium objectives of halving poverty by 2025
  will not be attained
• Overly complex and costly to monitor
• Does not address one of the reasons for high IFI
  debt in the first place have IFI/World Bank
  operations changed? After-completion
  point debt is on the rise
• No clear plan for after-HIPC market access

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HIPC as Debt Resolution Instrument

• Solutions?
• Simplify it
• Promote HIPC as debt reduction (not simply
  poverty reducing)
• Use a market-based approach to satisfy future
  financing needs. Give incentives to good
  performers to graduate from IFI assistance and
  ease their access to markets
• Grants for the poorest only (this is not in vague
  however)
• Key problems to Africas growth still to be
  tackled (i) political/ethnic governance (ii)
  trade access to foster growth (some progress).

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Pressure is on the G-8 Live 8
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Is the new G-8 debt relief initiative the
solution?

• Objectives
• 100 debt relief on IDA, IMF, and AfDB debt for
  countries reaching the completion point (18 now,
  17 later)
• Double aid for Africa (US50 billion) by 2010.
  Use innovative instruments such as the IFF
• Improve transparency governance at the
  receiving end
• But some key issues clearly remain (trade access
  promoting market-based approaches to satisfy
  future financing needs, etc).

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Section Five

• Historic Overview
• Why Sovereign Debt Exists?
• Reasons for Sovereign Debt Crisis
• Debt Resolutions, including HIPC
• Hot issues today

Hot Issues Today
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Hot Issues Today

• Advanced economies
• Short-term issue US fiscal imbalances,
  indebtedness, and global macroeconomic imbalances
• On the long run we are all ... debt (S P)
  Pension and other old-age related government
  liabilities pose a major threat to long-term
  fiscal sustainability in the advanced world

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On the long run we are all ... debt

• Rising government debt (on unchanged policies)

• can lead to drastic downgrading

Italy
Maastricht crit.
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Hot Issues Today

• Emerging Markets
• Impact of US interest rate increases may be
  significant, but EMs are better prepared for a
  shock than before
• Argentina-factor Has Argentina changed the rules
  of the game for sovereign default therefore for
  sovereign debt? Not the probability of default
  (PD), but the loss-given-default (LGD) value
• Impact of Basel II on capital inflows to EMs in
  Basel IIs more risk-sensitive world, low-rated
  sovereigns (particularly OECD members) may see a
  reduction in capital and/or increase in spreads.

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Sovereign Debt, Debt Crisis,and Debt Resolution

• Piroska M. Nagy
• EBRD