This article summarizes the book “When Sovereigns Go Bankrupt” (Gaillard 2014), which provides a fresh analysis of how to cope with sovereign risk in the context of a rising likelihood of default.
The complex relationships between sovereign debtors and their creditors
In the 16th, 17th, and 18th centuries, sovereign states borrowed to wage war but then would sometimes refuse to honor their financial commitments, plunging merchants and bankers into bankruptcy. With the advent of the Pax Britannica, relationships between creditors and debtor states evolved and became less inimical to investors.
Since 1815, the relationships between sovereign debtors and private creditors have been increasingly based on the rule of law, and also states have become more accountable for their debt policy. These trends have been reinforced since the 1970s for several reasons. First, the restrictive approach to sovereign immunity – which distinguishes between acts of government and acts of a commercial nature – has gained ground in Western countries and has thus discouraged governments from not honoring their financial obligations. Second, the prominent role played by the International Monetary Fund (IMF), especially since the 1980s, has enabled some low- and middle-income countries to avoid default. Third, the growing public debt in both industrialized and developing economies has obliged governments to launch active debt management strategies and has motivated investors to strengthen their monitoring.
However, that creditor-friendly path has not prevented some major defaults. In the 20th century, 94 countries defaulted on their foreign-currency bond or bank debt. More recently, most economists, financial analysts, and policy makers failed to anticipate the economic debacle of the Hellenic Republic. In November 2008, several weeks after Lehman Brothers collapsed, the country was still rated in the single-A category by major credit rating agencies and the Greek-German 10-year bond spread was no more than 160 basis points (Gaillard 2011).
Despite the support package offered by the European Union (EU) and the IMF in May 2010, Greece had to restructure its debt, dividing the burden between private and official creditors. In February 2012, private bondholders “voluntarily” (!) accepted a nominal haircut amounting to 53.5 % of the face value of Greek sovereign securities; at the same time, EU member states agreed to a new loan at a lower interest rate. Yet, since 2012, Greek unemployment has remained very high, driving young workers to migrate; austerity measures have undermined the legitimacy of the political system; and Greece is likely to restructure its public debt in 2015 or 2016. The idea behind my book originates in this “lose-lose” situation.
Identifying/protecting against/preventing/anticipating sovereign risk
Chapter 1 examines the key concepts used throughout the book. This chapter discusses why the notion of “creditworthiness” is better suited than those of “solvency” and “bankruptcy” for explaining sovereign risk and goes on to show that the risk of sovereign default depends on the country’s ability and willingness to pay. Next, Chap. 1 investigates the various policies that a borrowing state may implement to alleviate its debt burden. These policies include repudiation, missed payment, moratorium, unilateral and negotiated restructuring, exchange control, and special tax on bonds. Debt repudiation has historically put creditors in serious jeopardy (e.g., Mexico in the last third of the nineteenth century and Russia in the aftermath of the Bolshevik revolution). Yet forced debt restructurings, lengthy renegotiations, and even negotiated restructurings – especially when influenced by political factors (e.g., Iraq in 2006) – have also led to heavy losses for creditors. Even though it is not tantamount to default, monetary erosion is another major threat to debtholders.
Chapter 2 analyzes the various means used by creditors to mitigate sovereign risk well in advance – that is, when countries issue bonds, sign loan agreements, or are at an early stage of their borrowing cycle. Section 2.1 looks at sovereign bond and loan covenants: it presents the clauses that enable creditors to enforce contracts, secure repayment flows, avoid subordination, neutralize the risk of repayment on unfavorable terms, obtain specific guarantees, and make debt renegotiations easier once a default has occurred. The main provisions studied here are the choice of law, arbitration, currency, pari passu, and collective action clauses as well as pledges, negative pledges, and “inflation-proof” clauses. Section 2.2 addresses the various insurance and insurance-like instruments that investors can rely upon to hedge against default risk; these include sovereign risk insurance covenants, contracts of guarantee offered by multilateral agencies, and credit default swaps.
Chapter 3 investigates how some investors have been able to interfere with the debtor’s economic policy by insisting that measures be taken to reduce the risk of default in the short and medium term. Such interference can be direct or may be more subtle. Section 3.1 analyzes the role played by certain financial and economic advisors to foreign governments, many of whom were affiliated with a public or private institution that was a creditor to the focal country. Section 3.2 addresses the concept of conditionality and shows how states, bankers, and such international institutions as the IMF have made their lending conditional on the implementation of specific policies. There is a specific focus on the conditionality imposed by the IMF: its policy instruments have traditionally involved currency devaluation to boost exports, anti-inflationary measures to restore monetary credibility, and fiscal restraint to reduce public indebtedness.
Chapter 4 studies the various tools that investors can use to discriminate among borrowers and forecast debt crises. Section 4.1 describes the traditional indicators of sovereign risk – bond yields and spreads as well as ratings provided by Fitch, Moody’s, Standard & Poor’s, and Euromoney Country Risk (ECR) – and identifies their determinants. It is worth noting that sovereign bond spreads reflect more than country-specific fundamentals; in contrast to other risk indicators, risk premiums are strongly affected by liquidity and market sentiment. Section 4.2 compares these various indicators. Credit rating agencies and ECR ratings are strongly correlated with one another, but their correlation with 1- and 10-year sovereign bond yields is weaker. Section 4.3 demonstrates that sovereign debtors must overcome seven types of risk in order to preserve their creditworthiness: natural disaster, geopolitical risk, institutional and political risk, economic risk, monetary and exchange rate risk, fiscal and tax-system risk, and debt-related risk.
Beyond sovereign risk: financial repression?
In conclusion, I insist that some governments have tried to overcome the “default or consolidate” dilemma by exerting financial repression. This approach – which may include (among other measures) negative interest rates, purchases of sovereign debt by the central bank, capital controls, a tax policy that constrains savers to buy and hold sovereign bonds, and/or stricter supervision and control of the banking sector – has been used by the governments of both industrialized and developing countries. The financial repression phenomenon trims creditors’ returns and reflects the ongoing complex relations among a state, its central bank, and its creditors. More fundamentally, it shows that any government is capable of taking heterodox monetary or financial measures to remain solvent. In other words, a struggling sovereign borrower is a unique debtor because it may adopt the path of least resistance and continue to honor its financial obligations.