Voice at the Point of Sovereign Default

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Depositors in Buenos Aires, Argentina protest the freezing of their accounts, mostly in dollars. They were converted to pesos at less than half their new value. February 6, 2002. Photo credit: Wikimedia Commons

Much has been written about the questionable legitimacy of extending credit to states where it is likely that the funds will benefit corrupt leaders, or where the terms of the debt are highly inequitable. We would like to focus on a different moment in the debt cycle: the point of default, and the loss of voice suffered by the Global South parties as they negotiate solutions.1 Prearranged, consensual institutions and procedures for crisis-management are absent for sovereign defaults. Private foreign creditors de facto enjoy greater freedom than developing country debtors to organize collectively, and often call on the support of their home governments in advanced economies, who are influential political actors not party to the original debt contracts. Consequently, these private investors exercise disproportionate influence at the time of default over the evolution of rules as they are adapted in response to new crises. Given that multiple possible technical solutions have been advanced over time, the interesting questions concern whose preferences the chosen solutions and newly-formed rules represent, and why.

Three sections follow. The first proposes an ethical framework that acknowledges the inevitability of shared risks between debtors and creditors in any long-term financial contract. Section two dissects three famous cases, outlining the ways that private financial businesses or their advocates exercised disproportionate voice, influencing decisionmakers to implement their preferred outcomes while ignoring the claims of sovereign debtors advocating more balanced solutions. Our conclusions propose that international institutions develop a more consistent and inclusive troubled sovereign debt framework, based on the norm of shared responsibility, which explicitly aims to equalize voice across different stakeholders. This would resemble national bankruptcy laws, which provide space and clear legal principles, rules, and procedures, under which diverse creditors and debtors negotiate.


The Ethics of Sovereign Debt Resolutions


Ideas matter, even in technically-sophisticated policy realms. The current de facto global sovereign debt regime for middle-income countries accessing private capital markets closely hews to what may be termed the “sanctity of contract” perspective. This view considers a defaulting debtor to be in intentional violation of a legal obligation, and thus culpable, assigning the debtor full responsibility for compensating creditors. Further, by granting recourse for creditors, proponents argue that debtors will not have an incentive to default. This framing ignores the reality that sovereign debt crises frequently result from unanticipated shifts in critical external parameters—from global macroeconomic or geopolitical conditions to innovation within dominant financial hubs in the Global North—which developing or emerging market countries cannot influence.

A second approach, which we label “shared risk,” provides an alternative ethical grounding. Its key assertion is that both parties to a debt contract engage in a calculation of future risks and rewards, and both intentionally accept the possibility of losses if the borrower is unable to pay, especially when default results from exogenous shocks the debtor cannot anticipate nor control. This perspective recognizes that if financial institutions are not held somewhat liable for their investment decisions, then they are encouraged to engage in risky behavior, as they benefit from gains but are able to pass on the costs of losses to debtors and third parties.2 Shared risk implies shared responsibility and apportioning of losses between creditors and debtors. Although the problem of “moral hazard”—the temptation to underestimate risk when the costs will be borne by others—exists for both parties, current practice focuses almost exclusively on reducing moral hazard for the debtor while routinely ignoring the equivalent for creditors. Advocating an ethics of shared risk would help reduce this imbalance.


Three Iconic Cases


In three iconic cases over the past half century involving sovereign international debtors in the Global South, solutions to crises tended to favor private creditors, reflecting norms embodied in the sanctity of contract model, which assigns borrowers full blame. This ideational backdrop resulted in unequal voice at the point of default for sovereign debtors from the Global South.


The Latin American Debt Crisis of the 1980s


In the 1970s, many Latin American countries borrowed heavily to support public investment in infrastructure and industrial expansion, following variants of an import-substituting industrialization strategy.3 Northern commercial banks, flush with Eurodollar and petrodollar deposits, were eager to lend. In 1979, the U.S. Federal Reserve began to raise U.S. interest rates to combat domestic stagflation, increasing costs on U.S. dollar-denominated debt. The U.S. rate rise rippled through global markets, blindsiding Latin American debtors and precipitating the debt crisis. In August 1982, Mexico’s finance minister, recognizing that his country could not make its quarterly interest payment, flew to Washington, D.C. for an emergency bridge loan. When North American banks learned of Mexico’s default, they began pulling credit to the region, provoking the spreading defaults they feared. The International Monetary Fund (IMF), the Bank for International Settlements (BIS), and the U.S. Treasury managed the crisis, arranging for IMF loans to Latin American governments, enabling them to meet their scheduled payments to the banks. Only in 1989, with the advent of the “Brady bonds,” was the loan principal partially written off and the debt securitized and sold. However, by the close of the 1980s, Latin American sovereign debtors owed more abroad than before the crisis, despite a decade spent making large annual net capital transfers abroad.

Curiously, defaulting Latin American sovereign debtors during the global depression of the 1930s fared relatively better than these same countries did in the 1980s.4 One explanation is that private international creditors lacked strong backing from their governments in the 1930s. In the United States, for example, not only were the debts to U.S. banks insufficiently large to threaten a U.S. banking crisis, the American government’s hemispheric priorities were reviving trade and improving the political relationship with Latin America. Moreover, the 1930s default occurred against the backdrop of a collapsing international financial system and its norms, such as the Gold Standard. There were no strong international institutions available to coordinate a response.

In comparison, during the 1980s the IMF coordinated both private and public sector creditors to negotiate among themselves and then jointly with each individual country, efforts supported by the U.S. government, which recognized the risks to the U.S. banking system. However, when the debtors reciprocally attempted to organize and bargain collectively in 1983–1984, U.S. government actors and influential media branded these efforts a “cartel” and aggressively offered sweetheart deals to countries defecting from the group.5 The U.S. Treasury’s successful and intentional strategy was to delay settlement until the most propitious time for American banks, resulting in unnecessarily heavy costs for debtor countries and their citizens. Moreover, sovereign debtors in similar financial situations ended up with different terms, as terms were negotiated independently for each country. Foregone alternative solutions included capping real interest rates, or an earlier imposition of something like the Brady Bonds, options proposed by Latin Americans early in the crisis.6 More radically, Northern governments could have supported repatriating flight capital, for which there was wartime precedent.7


The Asian Financial Crisis, 1997-1999


A decade and a half after the Latin American debt crisis began, the (East) Asian financial crisis hit.8 In the 1990s, the IMF, at the behest of its North Atlantic members, had encouraged capital account liberalization for rising middle-income economies, asserting that capital inflows would provide needed funds for investment as well as competitive discipline for inefficient and parochial local banks. The associated risks of overborrowing abroad by the private sector went unrecognized. Private portfolio investment in local stocks and government bonds flooded into these “emerging markets.” Confident East Asian banks also established subsidiaries in the advanced economies to which their home firms exported, borrowing from American and Japanese banks at the lower prevailing interest rates abroad, and relending the equivalent in local currency back home at higher rates. This was profitable, but only while the exchange rate remained fixed. Speculation by private market actors against the Thai baht provided the proximate trigger for the crisis. Portfolio investors began to exit baht-denominated government securities, and in August 1997 the Bank of Thailand ceased defending the exchange rate and approached the IMF for a loan. As in Latin America in the 1980s, fearful foreign investors spread the crisis throughout the region as they reacted to Thailand’s crisis by rapidly pulling their capital from Indonesia, Malaysia, Singapore, the Philippines, South Korea, and other neighbors.

Once again, the U.S. government and the IMF together took leadership, and prioritized U.S. banks receiving payment for their loans to Asian private actors, now effectively assumed by their home governments. Portfolio investors into Asia took losses, but Asian governments and their citizens bore the brunt of the costs. Significantly, prior to the crisis Thailand, Indonesia, South Korea, and others were neither fiscally irresponsible nor large sovereign foreign debtors. Rather, they became sovereign debtors confronting defaults only as a result of defending their economies in the midst of crisis. Consequently, when the IMF imposed austerity—normally a medicine for countries with chronic public deficits—as a prerequisite to qualify for multilateral assistance, economists familiar with the region judged this as being both harsh and irrational. Japan’s government, closer to the situation, disagreed with the prevailing Western diagnosis as to the cause and cure of the crisis.9 However, the IMF and United States ignored Japan’s analysis. Malaysian Prime Minister Mahathir Mohamad resisted the proposed solution, rejecting IMF help in favor of controls to stem capital flight, policies excoriated in Washington as blatant cronyism protecting Mahathir’s political allies. Ultimately, Malaysia’s economic and social suffering was less than its neighbors.10 Adding insult to injury for the Asian economies that had accepted these stringent conditions, when financial contagion spread to Russia, Brazil, and others, IMF conditionality gradually became more country-specific and flexible.11 However, it was too late for those Asian countries that already had made deals. Once again, the global financial authorities allocated costs disproportionately toward borrowers, while rescue conditions were unequal for similar debtors.


Argentina Battles the Vultures, 2005-2016


While Argentina’s misfortunes did not spark regional financial contagion, they figure prominently in international debt debates due to the disjuncture between what many observers view as just and the actual legal process.12 Following ruinous hyperinflation, in 1991 Argentine policymakers adopted a “permanent” one-to-one link between the Argentina peso and U.S. dollars in the central bank, reinforced with a “Convertibility Law” making devaluation illegal. The IMF approved, inflation dissipated, and growth followed, allowing the government to borrow internationally via dollar-denominated sovereign bonds. As the peso gradually became overvalued, the IMF hesitated to criticize the fixed exchange rate regime publicly, partially to preserve its own reputation as an advisor.13 In 1998 contagion from East Asia led to IMF loans to both Brazil and Argentina. In early 1999 Brazil, Argentina’s main export destination, devalued its currency—but still Argentina held on. By 2001, political and economic crisis engulfed Argentina. Only after provincial governments began issuing their own currencies, followed by the central government’s sovereign default, a domestic banking crisis, and multiple leadership substitutions did a new president accept the inevitable, devaluing the peso in January 2002.

Frustrated by their experience with the IMF, subsequent Argentine policymakers opted to repay their IMF debts early and handle private creditor rescheduling themselves. Argentina put forth bond exchange offers in 2003, 2005, and 2010, by which time 93 percent of private creditors had accepted the “haircut” implied in the swapped new bonds. At this point, Argentina’s independent strategy appeared to be succeeding. However, Argentina’s bonds had been issued in New York, where boilerplate wording (a “Rights upon future offers,” or RUFO clause, valid through 2014) for reschedulings specified that, should any holdout creditors receive full payment, the government would retroactively compensate all other bondholders. In that era, collective action clauses (CACs), which specify that future rescheduling agreements accepted by a super-majority (often three-fourths) will be binding on all bondholders, were uncommon in the United States. Meanwhile, financial market innovation enabled the rise of a new type of actor: specialized hedge funds (known in the financial markets as “vulture funds”) whose core business model was to buy distressed corporate debt cheaply, then sue for full payment, in the hope that escalating legal costs would cause troubled debtors to cave in to their demands.

Vulture funds purchased the remaining 7 percent of unrescheduled Argentine federal government bonds, at huge discounts, and then implemented the strategy of suing until the target—in this case, an entire country—confronted escalating economic hardship and met their demands. Moreover, in 2012, New York Court of Appeals Judge Griesa ruled that Argentina could not even continue payments to the 93 percent of bondholders who had accepted the earlier swaps, with penalties for any financial institution that facilitated such payments. Despite widespread condemnation, Argentina was stuck until a new government finally settled with the holdouts in 2016. That President Maurício Macri then (foolishly) determined to issue a slew of new sovereign bonds, which soon also hit trouble, does not undermine the poignancy of the saga as it affected ordinary Argentines.

The importance of decisionmakers’ discretion can be found by comparison with a similarly-situated country. Although Greece had a similar crisis in 2010, policymakers were fortunate that the majority of their bond issues had been issued domestically; national regulators readily endorsed retrofitted CACs. By contrast, Argentina had the misfortunate to have its case heard by a U.S. judge who was vocally unsympathetic to that country.14 Argentina’s lawyers and an array of other parties, including the United Nations General Assembly, protested that an entire country should not be driven into the functional equivalent of debtors’ prison (unable to borrow to support the normal operations of government, and even prevented from making previously-agreed upon payments to the 93 percent of cooperating bondholders) at the behest of profit-seeking financial speculators.15 However, U.S. financial regulators and other federal authorities declined to intervene. The case ultimately reached the U.S. Supreme Court, which also declined to hear it. Meanwhile, as a foreign state, Argentina could not avail itself of the basic protections offered to domestic firms and individuals by the U.S. corpus of bankruptcy law. Had the ultimate victims been American citizens, rather than foreigners lacking local political or economic clout, it is likely that senior executive branch officials would have acted. Instead, the decision of one judge who went to unusual lengths to punish Argentina and the choices of most U.S. regulators and politicians to stand aside, excluded Argentina from private capital markets for over a decade.


Conclusions: Ethics and Voice When Conditions Morph


The path toward fairer, more ethical outcomes lies in evolving institutions that recognize the norm of shared risk (and thus shared responsibility for assuming costs to exit crises) in global financial markets. At a minimum, this implies intentional movement toward institutions and processes dedicated to equalizing voice between private creditors from powerful countries and struggling sovereign debtors in the Global South. While the current patchwork system encourages limited contractual and insurance protections for sovereign debtors, pre-specified rules simply cannot keep up with the myriad of innovations in finance, law, and economics that constantly create new risks. Durable solutions require reexamining traditional norms plus practical institutional innovations, from ensuring equivalent access to expert negotiators to a more consistent global governance framework.16

Given greater voice, sovereign debtors facing default embrace solutions allocating losses and costs across both lenders and borrowers, both of whom have knowingly assumed risk, rather than resolutions that assume debtors are solely culpable. In each case examined in this essay, more balanced alternative solutions were raised by borrowers, but ignored by de jure or de facto decisionmakers primarily responsive to the voices of private financial investors in the Global North.17 In the 1980s Latin American debt crisis, the IMF facilitated discussions among creditors, who then coordinated their strategies toward individual sovereign borrowers. When debtor countries also attempted cooperation, they were attacked as a “cartel.” In the Asian financial crisis, U.S. dominance of multilateral financial institutions led the IMF to impose harsh conditions in East Asia, despite Japan’s willingness to lead in identifying less punitive solutions. In the Argentine and similar cases, one alternative frequently raised, but rejected, was to exchange defaulted bonds for bonds with payouts linked to future exports or economic growth, a solution with the added virtue of aligning incentives across countries and bondholders.

If sovereign debtors should not be able to brush off their contractual obligations during a crisis, it is equally mistaken to allow creditors to escape the adverse consequences of their financial risk-taking. Risk-sharing is both an ethical and a practical position. No financial contract, however complete, can anticipate all problematic events. There are always “black swans,” or unexpected shifts requiring the evolution of new rules to manage them.18 Therefore, the best foresight constitutes prior agreement on balanced procedural rules and roles for adjudicating disputes and exercising discretion during crises. Voice for sovereign borrowers stands as an essential component. While designing appropriate institutional reforms to equalize voice is by no means straightforward, in the realm of sovereign debt negotiations we need to begin with endorsing the underlying ethical principle itself.19

Leslie Elliott Armijo and Prateek Sood

Leslie Elliott Armijo studies the politics of international finance. Her recent works include “Regionalism, Multilateralism, and Sovereign Debt: Observations from a Latin Americanist,” (Global Perspectives 4:1, 57547, 2023), “The Monetary and Financial Powers of States,” coauthored with D.C. Tirone and H-k Chey (New Political Economy 25:2, 2020), and The BRICS and Collective Financial Statecraft, coauthored with C. Roberts and S.N. Katada (Oxford University Press, 2018). She is adjunct professor of International Studies, Simon Fraser University, and non-resident senior fellow at Boston University Global Development Policy Center.

Prateek Sood holds a B.A. in Economics and International Studies from Simon Fraser University, and an M.A. in Global Development Studies from Queen’s University. He currently works in the Strategic Policy and Innovation Unit at the City of Toronto.

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  1. See also our longer work in progress, Leslie Elliott Armijo and Prateek Sood, “Ethics, Investment, and Sovereign International Finance,” unpublished paper.
  2. John Kay, Other People’s Money: The Real Business of Finance (New York: PublicAffairs, 2016) emphasizes the moral hazard for private investors embedded in contemporary financial regulatory frameworks.
  3. This case draws on Vinod K. Aggarwal, Debt Games: Strategic interaction in international debt rescheduling (Cambridge: Cambridge University Press, 1996), pp. 333-515; David Felix, “Latin America’s Debt Crisis.” World Policy Journal, 7:4 (1990), pp. 733–771; Ethan Kapstein, Governing the Global Economy: International Finance and the State (Cambridge, MA: Harvard University Press), pp. 58-102; José Antonio Ocampo, “The Latin American Debt Crisis in Historical Perspective,” in Joseph E. Stiglitz and Daniel Heymann, eds., Life After Debt: The Origins and Resolutions of Debt Crises (London: Palgrave-Macmillan, 2014); José Antonio Ocampo, Resetting the International Monetary (Non)System (Oxford: Oxford University Press, 2017); Anthony Sampson, The Money Lenders: Bankers and a World in Turmoil (New York: Viking Press, 1982); and Barbara Stallings, “Debtors versus Creditors: Power Relations and Policy Responses to the 1980s Crisis,” in David Felix, ed., Debt & Transfiguration: Prospects for Latin America’s Economic Revival (London: Routledge, 1990).
  4. Ocampo, “The Latin American Debt Crisis,” and Stallings, Op.Cit., each independently conclude that Latin American debtors fared better in the 1930s than the 1980s.
  5. Aggarwal, Op.Cit. chronicles the offers and counter-offers in the three-way negotiations (borrower government, creditor banks, creditor governments and multilateral institutions) for each individual Latin American country.
  6. Stallings (Op.Cit., pp. 87-90) notes that Japanese creditor banks and their government were also early advocates of a swap of bank loans for securitized bonds, but were overruled by U.S. banks and their government.
  7. Felix, Op.Cit. pp. 759-760.
  8. For this case, see Paul Blustein, The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF, Revised ed. (New York: PublicAffairs, 2003); Saori N. Katada, Banking on stability: Japan and the cross-Pacific dynamics of international financial crisis management (Ann Arbor: University of Michigan Press, 2001), pp. 172-209; Henry Laurence, “Japan and the New Financial Order in East Asia: From Competition to Cooperation,” in L.E. Armijo, ed., Debating the Global Financial Architecture (Albany, NY: SUNY Press, 2002), pp. 214-235; Dani Rodrik and Ethan B. Kaplan, “Did the Malaysian Capital Controls Work?”, Working Paper 8142 (Cambridge, MA: National Bureau of Economic Research, February 2001) http://www.nber.org/papers/W8142; Joseph E. Stiglitz, Globalization and Its Discontents (New York: W. W. Norton, 2002.
  9. Katada, Op.Cit.; Laurence, Op.Cit.
  10. Rodrik and Kaplan, Op.Cit.
  11. On differential treatments of diverse sovereign debtors as the chorus of critics swelled, see especially the book length treatments by Blustein, a financial journalist (Op.Cit.), and Stiglitz (Globalization and Its Discontents), chief economist at the World Bank during the Asian financial crisis.
  12. Key sources include Eugenio Díaz-Bonilla and Hector E. Schamis, “From Redistribution to Stability: The Evolution of Exchange Rate Policies in Argentina, 1950-98,” in Jeffrey A. Frieden and Ernesto Stein, eds. The Currency Game: Exchange Rate Politics in Latin America. (Washington, D.C.: Inter-American Development Bank, 2001); Martín Guzman, “An analysis of Argentina’s 2001 default resolution,” Comparative Economic Studies, 62:4 (2020), 701-738; and Brad Stetser and Anna Gelpern, Anna, “Pathways through financial crisis: Argentina.” Global Governance, 12:4 (2006), 465-487.
  13. Setser and Gelpern, Op.Cit.
  14. Jonathan Blitzer, “A Good Week for Vulture Funds,” The New Yorker, March 5, 2016, https://www.newyorker.com/business/currency/a-good-week-for-vulture-funds.
  15. Kanad Bagchi, UN General Assembly Resolution on basic principles on debt restructuring processes: A first step towards a global state bankruptcy regime? Euro Crisis in the Press, October 8, 2015, https://blogs.lse.ac.uk/eurocrisispress/2015/10/08/un-general-assembly-resolution-on-basic-principles-on-debt-restructuring-processes-a-first-step-towards-a-global-state-bankruptcy-regime/.
  16. A team of international financial lawyers detail the smorgsboard of sovereign international debt rescheduling innovations that have been employed, although without directly confronting the issues of power, norms, and voice raised here. See Lee C. Buchheit, Guillaume Chabert, Chanda DeLong, and Jeromin Zettelmeyer, “How to Restructure Sovereign Debt: Lessons from Four Decades,” PIIE Working Paper 19-8, Washington, D.C. Peterson Institute for International Economics, May 2019, https://www.piie.com/publications/working-papers/how-restructure-sovereign-debt-lessons-four-decades.
  17. The contrast with reactions in the Global North to the 2008-2009 global financial crisis, which threatened important financial institutions and markets in the Global North, has been stark. See Homi Kharas and Johannes F. Linn 2016. “Hypocrisy in financial crisis response: East Asia 1998 versus the USA 2008” (Washington, D.C.: Brookings Institution, July 28, 2016), https://www.brookings.edu/articles/hypocrisy-in-financial-crisis-response-east-asia-1998-versus-the-usa-2008/
  18. Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, 2nd ed (New York: Random House, 2010).
  19. Reforms within the multilateral financial institutions to date mostly have centered on providing the Global South more seats at the table in existing financial governance bodies. Meanwhile, private banks and institutional investors fiercely resist expanding the remit of such oversight bodies into financial issue arenas, such as commercial lending to middle-income country governments, that might reduce profits.

Category: Online Exclusive, Roundtable: Emerging Issues in Sovereign Debt

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