Both the number and percentage of countries in default reached record highs during the globalization years (1991–2016). In 1994, 114 sovereign debtors – accounting for 54% of all countries in the world – had failed to repay debt to their public or private creditors. This figure fell 10 percentage points by 2016, but it remained higher than any year during 1960–1981. Yet unlike what occurred in the 1930s and 1980s, no massive wave of sovereign bond or bank defaults was observed during 1991–2016. The explanation for this paradox involves (a) official creditors and China agreeing to restructure more sovereign debts and (b) private creditors managing to cut their losses by exploiting the new international financial architecture and a more secure legal environment.
How Official Creditors and China Absorbed Losses
In 1996, the international financial community launched the Heavily Indebted Poor Country (HIPC) Initiative in order to reduce the external debt of low-income economies. The Paris Club – as well as multilateral, non–Paris Club official bilateral, and private commercial creditors – all participated in this program. The initiative’s eligibility criteria required that candidate countries have: an unsustainable debt burden (even after obtaining traditional debt relief); a track record of sound policies through IMF- and World Bank-supported programs; cleared any arrears with the IMF, the World Bank, and the African Development Bank (AfDB); and prepared a credible “poverty reduction strategy” (see IMF 2019, pp. 7–8).
In 2005, the Multilateral Debt Relief Initiative (MDRI) complemented the HIPC Initiative. Under the MDRI, several agencies – including the IMF, the International Development Association (IDA), the African Development Fund (AfDF), and later the Inter-American Development Bank (IaDB) – committed to alleviating the debt burden of low-income economies. By the end of 2017, the total costs of debt relief to creditors under the HIPC Initiative and the MDRI were estimated at $76 billion and $43 billion, respectively (IMF 2019, pp. 12–14).
In addition to these specific programs, the Paris Club continued to reschedule and cancel the external debt of low- and middle-income economies. For all types of treatments, the Paris Club signed 248 agreements involving 79 countries during 1991–2016.
The high proportion of defaulting sovereign debt issuers in the 1991–2016 period was driven also by the many debt restructurings and write-offs negotiated by China and its state-owned banks, especially since 2000. This pattern reflects both the weak credit rating system used by Beijing and the poor credit position of its debtors – an interpretation supported by the massive defaults in 2016 of Angola, Cuba, and Venezuela on their debt to China.
How Private Creditors Limited Losses
Several of the sovereign debt crises that arose during 1991–2016 involved major, “systemic” economies. In the context of financial globalization, these shocks threatened not only private creditors but also the international financial community as a whole. In order to prevent a systemic crisis, policy makers instigated a new international financial architecture that proved to be a boon for private creditors.
This new architecture was shaped around the IMF. It became manifest in 1994 when that Washington-based institution – supported by the US Treasury and the World Bank – intervened to stop capital outflows from Mexico, thereby preventing a default and, quite possibly, a serious international financial crisis. These same players were at work in 1997 to resolve the East Asian crisis. In the following years, other bailouts were secured for major emerging countries (e.g., Brazil, Colombia, Turkey) so that they could remain solvent.
These last-resort loan interventions reduced the number of governments in default on their bond debt and cut the percentage of distressed debt owed to private creditors (i.e., among the total sovereign debt in default) from 65% in 1992 to 22% in 2011. Nonetheless, IMF economists admitted that such bailouts were likely to encourage both debtor and creditor moral hazard. Debtor moral hazard was identified in the loans to Argentina in 2000–2001 (Jeanne and Zettelmeyer 2005, pp. 79–80), and creditor moral hazard seems to account for the massive private capital inflows to Russia before its bankruptcy in 1998 (Mussa 1999, pp. 228–229).
The IMF conditionality required that distressed countries accept restrictions minimizing the problems associated with debtor moral hazard. However, a side effect of both financial globalization and the new international financial architecture is that creditor moral hazard remains a fundamental challenge for policy makers.
Another factor that strengthened creditors’ position was the enhanced legal and contractual protection of their rights. Thus, for example, the Foreign Sovereign Immunities Act of 1976 and the US Supreme Court’s statement that the issuance of debt was a commercial act (see Republic of Argentina v. Weltover, 1992) virtually consecrated the restrictive theory of sovereign immunity. This new paradigm spurred the insertion of clauses favorable to creditors in sovereign bond contracts. So starting in the 1990s, contracts were more likely to include a waiver of the sovereign’s immunity from suit and execution. Other clauses (e.g., “consent to jurisdiction” and governing law clauses) were inserted to facilitate the enforcement of sovereign debt contracts (Weidemaier 2014).
Such enforcement became uncertain when creditors doubted their status or disagreed over how best to cope with a distressed sovereign debtor. The fear of legal subordination in favor of another creditor led to a proliferation of pari passu clauses. By the same token, the need to expedite debt restructuring deals favored the insertion of so-called collective action clauses (e.g., collective modification provisions and collective acceleration provisions).
Despite these protections, bondholders have suffered some setbacks in the recent years. For instance, they were forced to accept haircuts exceeding 50% after the debt restructurings of Argentina and Greece in 2005 and 2012, respectively (Gaillard 2014, pp. x, 11). Bondholders have also encountered some coordination problems. The successful strategies followed by certain holdout creditors (e.g., the lawsuits brought by Elliott Management against Argentina) suggest that a creditor’s most dangerous opponent might well be another creditor.
References
Gaillard, N. (2014), When Sovereigns Go Bankrupt – A Study on Sovereign Risk, Springer, Cham.
International Monetary Fund (2019), Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI) – Statistical Update, IMF Policy Paper, August, Washington, DC.
Jeanne, O. and Zettelmeyer, J. (2005), “The Mussa Theorem (and Other Results on IMF-Induced Moral Hazard),” IMF Staff Papers, Vol. 52, IMF Conference in Honor of Michael Mussa.
Mussa, M. (1999), “Reforming the International Financial Architecture: Limiting Moral Hazard and Containing Real Hazard,” in Gruen, D. and Gower, L. (Eds.), Capital Flows and the International Financial System, Reserve Bank of Australia, Sydney.
Weidemaier, W. M. C. (2014), “Sovereign Immunity and Sovereign Debt,” University of Illinois Law Review, Vol. 2014 (1).
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