Sovereign Default

This chapter begins by defining sovereign default. It proceeds to untangle several common forms of default, including unilateral and negotiated default, and default that results in principal haircuts and payment reprofiling, and offers a clear taxonomy of default, using real-world examples when needed. The chapter then explores the various costs of sovereign default, and the factors that influence them. It considers some of the weaknesses and distortions within the existing framework of crisis prevention and resolution, highlighting the role of official bailouts and moral hazard, and the causes of delayed and inadequate debt relief (“too little, too late”). The chapter concludes with recommendations for reducing the incidence and cost of default.

The Motive to Borrow

Governments issue debt for good and bad reasons. While the good reasons—intertemporal tax smoothing, fiscal stimulus, and asset management—can explain some of the increases in public debt observed in recent years, they cannot account for all of the observed changes. Bad reasons for borrowing are driven by political failures associated with intergenerational transfers, strategic manipulation, and common pool problems. These political failures are a major cause of overborrowing and budgetary institutions and fiscal rules can play a role in mitigating the tendency to overborrow. While it is difficult to establish a clear causal link from high public debt to low growth, it is likely that some countries might be paying a price in terms of lower growth and greater output volatility because of excessive debt accumulation.

Introduction

Not since the aftermath of the Second World War has the topic of sovereign debt taken such importance in public policy debate. Reeling from the effects of the Global Financial Crisis, public debt-to-GDP ratios in advanced economies are at levels not seen in over half a century....

Reducing Debt Short of Default

If debt is too high, what policies are available to governments to reduce these debt obligations? This chapter goes through all options, short of default. It begins by introducing the standard debt accumulation equation, noting the key terms, such as the growth–interest rate differential; and their relation to policies. Once this is established, the more conventional strategies for reducing debt—promoting growth and fiscal consolidation—are explored. Particular emphasis is given to the impact of fiscal multipliers, and the factors that influence their magnitude. The chapter then moves on to more unconventional policies, such as inflation, seigniorage and financial repression.

Debt Management

Chapter 4 illustrated the factors that can undermine debt sustainability; this chapter builds on that by exploring the role of debt managers in reducing these risks. The chapter begins with the motives of the debt managers, including to minimize the risk–cost trade-off; but also bigger picture motives, such as the allocation of risk between the public and private sector. It also shows how the composition of sovereign debt can have important macroeconomic implications, such as via the monetary policy transmission mechanism. The chapter details the risks from maturity, currency, and residency, including the “original sin” problem faced by some countries. It concludes with a discussion of the role of debt managers in pursuing other objectives, such as financial deepening.

Public Debt through the Ages

We consider public debt from a long-term historical perspective, showing how the purposes for which governments borrow have evolved. Periods when debt-to-GDP ratios rose explosively as a result of wars, depressions, and financial crises also have a long history. Many of these episodes resulted in debt-management problems resolved through debasements and restructurings. Less widely appreciated are successful debt consolidation episodes, instances in which governments inheriting heavy debts ran primary surpluses for long periods in order to reduce those burdens to sustainable levels. We analyze the economic and political circumstances that made these successful debt consolidation episodes possible.

Challenges Ahead

The final chapter will give a perspective on topical issues on sovereign debt over the next decade. It focuses on the re-indebtedness of advanced, emerging, and low-income countries, and the risks posed by a changing creditor landscape. Yet despite this, by historical standards there have been relatively few debt crises in recent years—have these been avoided or merely delayed? The second half of the chapter then explores how risks associated with these issues can be reduced, first by improving crisis prevention policies, and then by strengthening crisis resolution policies.

The Restructuring Process

This chapter goes into depth on the debt restructuring process itself, a topic which has not been covered in the literature in detail before. It gives a step-by-step outline of how restructurings take place, from deciding on the appropriate strategy, to determining which debt should be covered and in what way; to engagement with creditors in the negotiating process. It also covers one of the main structural problems in reaching an agreement with creditors—the collective action problem—and explores ways by which such problems can be overcome with both private creditors (collective action clauses, exit consents) and the official sector (the role of the Paris Club).

Debt Sustainability

Why can Japan sustain debts above 200 percent of GDP, while Ukraine defaulted on its debt when it was 30 percent of GDP? This chapter investigates what causes a country to default and hence how to assess the sustainability of sovereign debt. It begins by looking at why a sovereign my renege on its debt operations—because it makes a strategic choice (willingness-to-pay models), or because it is forced to (ability-to-pay models). The bulk of the chapter will look at the different techniques for assessing debt sustainability, highlighting the work of the IMF as well as other models.

Concepts, Definitions and Composition

Comparisons of public debt across countries and across time are hindered by the significant heterogeneity in definition and coverage. Public debt in France in 1830 bears very little resemblance to that of Brazil in 2016. This chapter will consider what constitutes a debt contract and onion-like layers of the sovereign entity: the central government, local government, central bank, state-owned enterprises, etc. The chapter uses this taxonomy to show the varied landscape of debt today, in particular: who are the major creditors and debtors; what are the main financing instruments (bonds, loans, swap, etc.); and what are the terms of the bond (currency, maturity, cost). This chapter will act as a reference guide to all those who work on debt issues on a regular basis.