I’m Eve. In this article, I explain how, believe it or not, the United States once acted as a mediator in sovereign debt negotiations. Now that the US has ceded that role to private creditors, distressed borrowers are getting even tougher.
Article by Martin Guzmán (Professor at the School of International and Public Policy, Columbia University and Professor of Finance, Credit and Banking at the National University of La Plata), Maia Kolodenco (Director of the Sulamericana Vision Global Initiative) and Anahi Wiedenbrug (Research Associate at the Latin American Institute of Social Sciences). Vox EU
Many developing countries are currently facing debt crises, and sovereign debt restructurings are often delayed. Emerging market debt structures are shifting from Paris Club creditors to private lenders. In this column, we argue that asymmetries in coordination between private creditors and emerging market debtors affect fairness and efficiency. Private creditors are often better coordinated and able to extract power rents, suggesting that sovereign debt markets are not perfectly competitive. Historical cases such as the Cartagena Group of the 1980s are instructive examples of how borrower coordination works in practice.
Following two recent major external shocks, the COVID-19 pandemic and the monetary tightening in developed countries following the Ukraine war, many developing countries are currently facing debt crises. Despite some policy innovations since the pandemic, such as the Common Framework for Debt Treatment Beyond the Debt Service Suspension Initiative (DSSI), the International Debt Architecture (IDA) is still largely inadequate to support countries facing debt sustainability issues, and sovereign debt restructurings are being carried out “too little, too late.” The societal impacts of sovereign debt crises go beyond the interests of academics and policymakers. In a recent workshop at the Pontifical Academy of Social Sciences, Pope Francis called for the creation of a multilateral mechanism for the resolution of sovereign debt crises (Pope Francis 2024; see also Guzman and Stiglitz 2016).
In this context, it is interesting to look at past cases of heightened debt vulnerability, as history reveals the peculiarities of IDA’s current incentive structure. The Latin American debt crisis of the 1980s is a case in point. Since then, the debt composition of developing countries has changed significantly, including an increase in debt to non-Paris Club creditors and an increase in private bond debt as an important source of financing, with the latter now accounting for 47% of total emerging market and developing countries’ (EMDE) debt (Colodenco et al. 2023).
The current approach to debt crisis resolution, and the involvement of the United States in it, represents another important change. During the Latin American debt crisis, the United States took the lead in most debt negotiations, calling its debt restructuring plans the “Baker Plan” (after Treasury Secretary James Baker) and the “Brady Plan” (after Treasury Secretary Nicholas Brady). Former Federal Reserve Chairman Paul Volcker (1979-1987) left no doubt about the central role of the United States as a negotiator, boldly telling the New York Times, “I don’t know who thought they were making all these deals, but it was me” (Makoff 2024, p. 39). The involvement of the United States was aligned with US interests. During the era of syndicated loans, the US banking system was systemically exposed to potential defaults of Latin American countries.
A Central Intelligence Agency (CIA) report published in 1986 also reveals the role the United States played in collapsing debtor adjustment in the 1980s. According to the CIA report, the main motive was “the lack of negotiating power vis-à-vis the international banks,” and foreign and finance ministers of eleven Latin American countries met in Cartagena, Colombia, in June 1984 to formally establish the Group in the hopes of helping to strengthen their negotiating power vis-à-vis the international banks. According to our recent paper (Guzman et al. 2024), the Cartagena Group demonstrated the potential to help debtors exert their influence both ex ante (to favorably affect IDA) and ex post (to contribute to a fairer and more efficient restructuring outcome). Although the Cartagena Group was short-lived to have a significant impact on IDA, the group’s activities demonstrated its potential power in strengthening borrower adjustment.
The United States now has a more distanced stance in negotiating between distressed sovereign debtors and private creditors. After many Republicans felt that the IMF had provided too much bailout to private creditors of EMDEs, the US Treasury Department under George W. Bush announced that the IMF would withdraw from negotiations, leaving “sovereigns and their creditors to work out their own terms” and no restructuring would have to take place “without the involvement of a central group or committee” (Taylor 2002).
A question that arises is whether the exit of the United States as the primary dealmaker in IDA has created a more level playing field between EMDE debtors and private creditors. Guzman et al. (2024) argue that it has not. We show that private creditors have had a significant influence on the shaping of the current IDA. In the 1970s, developed country banks were successful in establishing coordination mechanisms that continue to this day. From the London Club to the International Capital Markets Association to the Institute of International Finance, private creditors have been successful in establishing institutions that coordinate to advance their own interests. The same degree of coordination does not exist among sovereign debtors, mainly due to the short-term incentives faced by debtor governments.
Guzman et al. (2024) argue that this asymmetry in the degree of coordination between private creditors and EMDE debtors affects fairness and efficiency both ex ante and ex post (see Table 1). The ex ante dimension refers to the ability of private creditors to shape the IDA rules governing the debt cycle. The ex post dimension captures the ability of private creditors to influence the outcome and process of debt restructuring. Certain characteristics of the system simultaneously involve both fairness and efficiency considerations. For example, the 9% compensatory pre-judgment rate for defaulted bonds under New York State law, currently being debated in the New York State Assembly, not only leads to favorable distributional outcomes for creditors but also affects incentives for sovereign debt crisis resolution, suggesting inefficiency.
table 1 The ability of private creditors to shape international debt architecture and restructuring in a fair and efficient manner
| fairness | efficiency | |
|---|---|---|
|
advanceAbility to shape the rules of the international debt architecture that govern the debt cycle. |
The rules of the international debt architecture and the domestic laws of the major national lending jurisdictions (principally New York State and the City of London) reflect the influence of private creditors. example: cross-default and acceleration clauses, the 9% compensatory pre-judgment interest rate on past due debt under New York law (which also leads to ex-post inefficiencies), and the elimination of Champerty under New York law (which affects the dynamics between debtors and bondholders and between cooperative and non-cooperative bondholders, leading to ex-post inefficiencies). |
The norms of the international debt architecture do not necessarily encourage sustainable lending decisions in times of debt crisis, when bailouts are expected. exampleThere is no definition of debt repayment capacity in the sovereign debt agreement, and no broader circumstances that justify a “risk premium” are identified. An IMF bailout is expected. |
|
after: Ability to influence the restructuring process and outcomes |
resultPrivate creditors have been successful in extracting rents from debtors (ex-post returns on global portfolios of foreign-currency government bonds are greater than “risk-free” benchmarks of UK and US government bonds; Meyer et al. 2022). processIn restructuring negotiations, private creditors tend to have greater negotiating power than sovereign debtors. |
resultDelayed and insufficient restructuring of the country’s unsustainable debt with private creditors will prevent economic growth from returning, creating a high probability of the need for repeated restructuring. processThe regime sets up incentives to delay the restructuring process and grant inadequate relief with a view to restoring debt sustainability in order to preserve the potential for upside revenues in the event of a positive shock under an incomplete contract. |
The implications of this paper are far-reaching, not only for the practical outcomes of IDA and debt restructuring, but also for the development of the sovereign debt field in academia.
First, the history of private creditors’ success in shaping the international debt architecture suggests that adjustments do not need to be perfect to effectively influence the infrastructure and environment in which restructurings take place. Past experiences of debtor adjustments highlight the extent to which the mere existence of a debtor group has changed the balance of power between creditors and debtors and reduced inequality. The content of a debtor adjustment does not necessarily need to be radical, since the mere existence of a group can already upset the balance of power between creditors and borrowers and the environment in which they operate.
Second, in terms of its academic contribution, our paper highlights the role of power in explaining sovereign debt outcomes. A central weakness of mainstream economic analysis of the sovereign debt issue is its reliance on competitive equilibrium models, the hallmark of which is the absence of any form of power. It would be unwise to ignore power in the analysis of sovereign debt.
Most sovereign debt models assume that an arbitrage equation defines the cost of financing, based on the assumption that markets are competitive and investors are risk-neutral, i.e., investors are indifferent to losses and equally sized gains. The risk premium in a transaction is compensation for risk taking. In a traditional framework, we see that over time, the risk premium compensates for losses associated with defaults and restructurings in riskier environments. If investors were risk-neutral, they would demand compensation for risk, such that the expected return on risky assets compensates for the opportunity cost posed by the risk-free interest rate.
However, recent evidence suggests otherwise. Meyer et al. (2022) compile a database of 266,000 monthly prices of foreign-currency-denominated government bonds traded in London and New York over a 200-year period (1815–2016), covering up to 91 countries. They find that the average real annual ex-post return on a global portfolio of foreign-currency-denominated government bonds is 410 basis points higher than the ex-post return on UK or US government bonds. These empirical findings strongly suggest that power rents exist; that is, lending to risky countries is good business, even better business than lending to risk-free countries.
Economics and political science need to study these topics more seriously, given the reality of the disproportionate power of international private lenders relative to developing countries.
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