Wednesday, June 22, 2011

Sovereign Default and Future Borrowing: A Query

Suppose Greece defaults on its foreign debts, as seems not unlikely. What would the effect be on its ability to borrow?

The obvious answer is that, having stiffed its creditors once, it will be unable to find new ones. But it is not obvious that it is true. The more the country owes, the greater the incentive to default. At present, from what I can judge of Greek politics at long range, it is not entirely clear that there is any other alternative; there may be no politically viable path to paying off the current indebtedness. Greece after default, like a company coming out of bankruptcy, may actually be in a better position to borrow than before.

There must surely be historical data on this question; Greece is not, after all, the first country to face the possibility of sovereign default. I, however, am lazy. So instead of doing research, I am putting the question to my readers.

In the past, when countries defaulted on their debts, did the interest rate they had to pay for future loans go up, or down?

Readers with long memories will realize that this is not the first time I have raised the general question.


Georgi said...

Bulgaria defaulted in 1990, restructured in 1994 (Brady bonds) and had crisis and hyperinflation in 1996-1997. All this time Bulgaria was unable to attract any foreign financing (including FDI).

Bulgarian situation started improving only when government started reforms in 1997 - privatization, tax reforms, liberalization of trade (internal and external), stable currency, fiscal surpluses. After that, Bulgaria got investment credit rating in 2004-2006. FDI and foreign financing started pouring after that.

Actually, it was not the restructuring or default that helped Bulgaria - it was the reforms. The restructuring in 2004 did not help at all, the economy was in collapse just 2 years later because government continued the same policies.

Anonymous said...

Most countries that default have their own currency. So they have no compulsion to immediately resume foreign currency borrowing after default.

The Greece situation is therefore unusual, unless they leave the Euro in addition to defaulting.

Doc Merlin said...

Georgi is correct, and as a Chicago guy you should intuit this, lenders tend to be forward looking, so they are more interested in structural issues than in total debt level (not that both aren't important, however).

Also you are wrong, the higher the debt level doesn't usually mean higher probability of hard default (at least not historically), iirc, (my memory may be faulty) the countries that tend to default usually do so below the debt to GDP ratio of 40%. (Trying to remember from reading This Time Its Different.

Douglas Knight said...

Argentina was practically the only country not to default in the Depression, hoping to be promoted to first world status, but was charged standard Latin American rates afterwards. It defaulted in 2002 and I think its interest rates have recovered by now.

lynn chu said...

Memories for bad things tend to be short. Cf., "The Art of Forgetting the Unpleasant" by John Cowper Powys.

Anonymous said...

I do not imagine the research would tell you much since defaults are usually proceeded by, accompanied by, and/or followed by structural reforms, austerity measures, and monetary expansion as governments attempt to avoid defaulting. Hard to tell, therefore, whether the swings in interest rates, or lack thereof is caused by the default or something else.
Theoretically, I imagine that the result of a default would be to decrease short-term interest rates and increase long term interest rates if there are no structural changes and inflation is expected to remain constant. The reason being that now that the country has already defaulted creditors do not expect it to be able to raise enough money in the future to pay them back, however being freed from the shackle of previous debt means that it will be able to meet short term commitments more easily (at least for a little while). The result of these countervailing trends would be to push up long term interest rates and push down short term interest rates. As the second day of reckoning comes nearer, however, creditors will abandon both short and long term debt. Still interest rates may go up (or, less likely, down) depending on how creditors are defining their time horizon. If the shortest term bond that Greece issues is considered long term by investors then interest may go up in general, though the increase should be more profound among longer term bonds.

Josiah Neeley said...

I think this paper (Is Debt Relief Efficient?) may be what you are looking for. From the abstract:

When developing countries announce debt relief agreements under the Brady Plan, their stock markets appreciate by an average of 60% in real dollar terms—a $42 billion increase in shareholder value. There is no significant stock market increase for a control group of countries that do not sign Brady agreements. The stock market appreciations successfully forecast higher future resource transfers, investment and growth. Since the market capitalization of US commercial banks with developing-country loan exposure also rises—by $13 billion—the results suggest that both borrower and lenders can benefit from debt relief when the borrower suffers from debt overhang.

Anonymous said...

"This Time is Different" by Reinhart and Rogoff will give you more data on this then is possible to consume. The short of it: countries that default are able to surprisingly quickly get back into the external debt market.

jdgalt said...

This topic, and the reasons for various kinds of financial misbehavior by national governments, are covered extensively in Blood in the Streets.

But here's more or less a short version: Elected officials tend not to look at anything beyond their next election day; while dictators don't even look that far. So both sorts of politicians spend as they please, unless something stops them.

A government spending money has to obtain it somehow, whether by taxing, borrowing, the printing press, or some combination. And for poor (non-G20) countries, borrowing pretty much means going overseas and borrowing in some rich country's money, one the poor country can't print. This is true for two reasons: the poor country's banking system is tiny (so it can't supply what its government wants), and no other country uses the poor country's money.

The result is about what you would expect. If a poor country can borrow at all, it has to pay interest rates that reflect both a high risk of default, and the inability of the lender to do anything about it.

Back in colonial days, if a poor country's government or institutions borrowed money from one of the major powers and then tried to default, the major country would enforce the debt by invading the poor country, or at least sending a fleet to conduct "gunboat diplomacy."

For what it's worth, I have no problem with this method of enforcement. But it has become no longer workable, not for any moral reason but because it's more expensive than it's worth, because weapons technology today (a) is much more evenly dispersed and (b) favors defense over attack much more than then.

Today, if a debtor country defaults, about the most that can be done to them is to try to isolate them with a boycott. This was the original reason the US has been boycotting Cuba's economy since Castro came to power. You can see how well that has (not!) worked: no third country has joined in the boycott, because it's in their short-term interests to keep trading with Cuba anyway.

Therefore every remaining loan to poor countries is more or less a ticking bomb, and they will all default when it suits their purposes.

It's an open question whether the same conclusions apply to the US government's debt to China. One would think that declaring war on us could not ever possibly be worthwhile, but a few years from now, when the US is suffering Argentine-level inflation and is having trouble paying and feeding its army, then they may beat us.

$9,000,000,000 Write Off said...

Russia in 1997 (?) defaulted and its interest rates are pretty normal. Give Argentina a decade and its default won't be reflected in interest rates.