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Econ101 – What Happens When a Country Defaults?

Sovereign debt default is in the news again after the Argentinian default a month ago, the eighth default by Argentina. Debt is the instrument through which a country can borrow money in the international market. Just as a new company requires loans to start up, emerging markets must depend on richer countries to finance their development needs. Just as a company may go bankrupt because of external factors, a country may be faced with economic crises that make it difficult to service (repay) its debt.

When a company finds itself in a position where it is unable to repay the principal and interest on its debt, it can choose to declare bankruptcy. Depending on the laws applicable, this implies that part of the debt may be “forgiven” by creditors in return for either the proceeds from the sale of assets owned by the company or for a plan for re-organisation of the company that must be approved by the creditors. Both these solutions depend on the ability of courts to enforce the agreement between debtor and creditors.

Similarly, when a country finds itself in a position where it is unable to service its debt, it can declare a sovereign debt default.

There are two main differences between bankruptcy and sovereign debt default. The first is that while courts within a country can enforce agreements between creditors and debtor, there is no international court that can enforce contracts between creditors and debtors from different countries. This lack of enforceability creates a host of problems. The second difference is that the government of the country which is the official debtor has a peculiarly different role to play than a single firm. There are many more implications of a sovereign default within the debtor country as compared to default by a single firm.

A major issue with the lack of enforceability is that if creditors are aware of the non-enforceability of contracts, why would they lend in the first place? And how can sovereign countries then raise funds? The obvious answer is reputation for repayment. If a country shows that it is credit worthy because it repaid loans in the past, then this reputational capital may be used to attract funding. In principle, a better credit history may imply better terms of repayment through lower interest rates. However, the reputational mechanism relies on the ability of creditors to punish the debtor country effectively, once default occurs. For example, if there is no punishment after default, the signal that debt will be forgiven in any case may lead to less effort on the part of the debtor country to repay debt. This undermines the reputation mechanism. This is a particularly salient issue when there are multiple creditors. A single creditor can re-negotiate or restructure debt with the debtor country much more easily than a group of creditors with competing claims on the distressed sovereign.

Enter the Argentinian crisis: in 2005, four years after its major sovereign default, the country had agreed on reduced debt servicing with the vast majority (75% of the defaulted bonds) of creditors, and in 2010 another 17% of the original bond holders agreed to the new terms. Thus all but a small minority of the bondholders agreed to the proposed “haircut” (the creditors were entitled to receive 65% of the promised repayment after the restructuring, in this case the haircut is 35%). The 8% of bondholders who did not accept the terms are known as “vulture” investors as they specialise in buying up cheap debt that other bondholders sell to them at reduced prices. Vulture funds (most famously Elliott Associates) then wait to capitalise on full repayment when the country comes out of the crisis. They sued the Argentinian government for full repayment according to the original terms of the bond plus the interest accrued (about 1.5 billion dollars). Had the debt been issued in Argentina, it would be handled by judges within Argentina. The problem was that the debt was issued in New York and thus subject to the American judicial system (this made it cheaper for Argentina to borrow money).

Judge Greisa, the governing judge in the case, has ruled in favour of the vulture funds and has prevented Argentina from paying back the restructured debt to other creditors until it pays the full amount asked for by Elliot Associates. This has virtually sent Argentina into an involuntary default. That’s where the situation is at the moment.

So, what’s going to happen now? What can Argentina do? Standard and Poor’s has already downgraded Argentinian debt. Usually, as after the Greek crisis, downgrading implies that countries will have to borrow at higher, and sometimes much higher, rates of interest. In the case of Argentina, this may not happen because investors realise the reason for the default is not in Argentina’s control.

In general a default occurs when a country is better off not paying its debt. However the costs of default include restricted access to credit (or worse terms of borrowing) not only from international markets but also domestic markets as the credibility of the government comes into question. Usually domestic banks hold a substantial amount of domestic debt. A default leads to a sudden loss of credibility which in turn may trigger bank runs and lead to a financial crisis as banks are unable to lend money. This feature of government default distinguishes it from a corporate bankruptcy. When a single firm goes bust the knock on effects on the economy are much smaller than when a government goes bust. Other costs of default include trade embargoes, drying up of foreign direct investment in the defaulting country and the political costs to the incumbent government.

All of these have effects on GDP growth. The evidence suggests however that most of these effects are short lived: countries face higher borrowing costs due to lower credit ratings for about 2-7 years on average, there is a big dip in growth in the first year after default but the effects are short lived. Of course, even if they are short lived the impact of default on citizens of the country can be substantial, especially if there are domestic bondholders. The government may not have the money to pay its own employees leading to knock on effects on the rest of the economy. The costs of default are lower when the country is less dependent on foreign investment and when it is able to use monetary policy to mitigate the effects of default (unlike the Greek case).

To dig deeper:

Borensztein, E., & Panizza, U. (2008). The Costs of Sovereign Default. IMF Staff Papers,WP/08/238.

Retrieved from: https://www.imf.org/external/pubs/ft/wp/2008/wp08238.pdf

 

AMRITA DHILLON

is a Professor of Economics at King’s College London. She is an Associate Editor of the Journal of Public Economic Theory and Social Choice and Welfare, and was recently elected to the council of the Royal Economic Society from 2014.

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