Ebook Sovereign Debt Without Default Penalties
It is widely recognized that sovereign debt differs from corporate debt in that the debtor cannot credibly grant the debtor (conditional) property rights over fixed assets or cash flows . Hence, most of the literature assumes that sovereign debt is enforced under the threat penalties — such as trade sanctions. However, an important branch of the corporate-debt literature assumes that cash flows are not verifiable so that rights to fixed assets are actually used as threat-points for potential renegotiations; see Hart and Moore (1998). It thus follows that sovereign and corporate debt are quite similar. In both cases the debtor repays under threat, the difference being more in the ability to adjust and refine the penalty; see Eaton and Gersovitz (1981) or Bulow and Rogoff (1989a, b) for classic references. The conclusion that sovereign and corporate debt both have similar incentive structure has quite important practical implications: c.f. Krueger’s (2002) proposal for a Sovereign Debt Restructuring Mechanism, which is modeled after Chapter 11 of the US Bankruptcy Code.
In this paper we consider an alternative (extreme) case where no penalty for default is implementable, so that sovereign debt must be supported by an entirely different incentive scheme. The main idea is that sovereign debt is structured so that it is in the best interest of the median voter to serve it. Two elements in this structure are critical; first, the debt should be tradable, so that in case of sanctions foreigners can sell the bonds to locals who would obtain repayment. Second, the debt should remain at the level at which the median voter still has an incentive to repay. Note that when domestic and foreign creditors hold identical instruments, default benefits domestic tax-payers but harms domestic bond holders, where the net effect depends on exact positions. The trick then is to find a level of debt where the interests of the median voter are more closely aligned with foreign bondholders than with local taxpayers.
This paper is partially motivated by a certain unease that the literature expresses about the current theory. While it is widely agreed that sovereign default may disrupt the debtor’s operations, there is a widespread feeling that the implied penalty is insufficient to support the level of activity that is observed in sovereign-debt markets. For example, Eichengreen (1988) finds no evidence for a negative relationship between pre-WWII default and post-war lending. Bulow and Rogoff (1989a) comment that, “admittedly, there are many uncertainties surrounding the actual damage which a lender can inflict on an LDC” following default.
They therefore dismiss reputational models where sovereigns repay just in order to preserve the capacity of further borrowing. Instead, Bulow and Rogoff (1989b) suggest that sovereign debt is enforced by penalties that creditors can enforce within their own jurisdictions, like trade sanctions. However, Tirole (2002) points out that such sanctions suffer from similar weaknesses, particularly a severe free-rider problem amongst creditors, combined with a strong incentive to renegotiate ex-post-inefficient sanctions. Note that all these problems result from the sharp separation between domestic and foreign creditors, so that all domestic interests are unanimously aligned against serving the debt. We avoid the difficulty by assuming that some domes-tic agents hold “foreign” debt, which breaks the unanimity and gives the median voter a genuine interest in serving the debt.
Unfortunately, it is hard to motivate our theory by direct statistical evidence about domestic positions of sovereign debt; namely the “home bias”. Often, the debt is held by custodians, who will not reveal the identity of the ultimate creditor even during “renegotiations” (see Gray (2003)). According to our own theory, this is not surprising, because it is essential that the line between the foreign and domestic position is not clearly marked. Yet, there is a widespread feeling, that a “large fraction of the [foreign-currency denominated] government debt was issued domestically and purchased by domestic banks”; see Roubini (2002). Perhaps more revealing is some anecdotal evidence. Thus, for example, on May 7, 1999 the Russian government announced that it would pay $333m interest on five out of seven tranches of bonds. The announcement was a great surprise as — according to a contemporary analyst “none expected to get any money in May”. A month later The Economist commented cynically that now that “a big chunk of ex-Soviet debt ... is held not by the original banks, but by hedge funds and other individuals” the repayment was actually “to the benefit of wealthy Russian individuals and institutions”. Then a year later, after reaching an agreement with the London Club to restructure $32bn of Soviet-era debt (on February 11, 2000) The Economist reported that “some observers ...note sourly that it has delivered a hefty profit to Russian banks which bought up the least popular category [of the debt]... at time its price had fallen following the leak of draft scheduling terms”.
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