Sovereign Defaults and Bailouts - Term Paper Example

 Sovereign Default This paper explores the concepts of Sovereign Defaults and Bailouts. It attempts to underline the causes of Sovereign Defaults, the benefits and costs associated with a Default. Sometimes, default is a choice made by policymakers. Moreover, it explores the advantages and disadvantages of a Bailout. While Bailouts avoid a sudden rupture that would leave a country unable to make future current transactions; but loans from IFIs come with conditions: usually centered on correcting the lax fiscal policy that created the vulnerability to default in the first place. You might choose to explain the nature of conditionality attached to loans; the importance of the IMF a crisis manager that can coordinate the actions of private creditors to prevent a run; and the problem of moral hazard 1. Introduction to Sovereign Default: Sovereign Debt is the debt brought on by Governments. (Hatchondo et al, 2007 p.163). A Sovereign Default is the failure in the repayment of Government Debt.[Sovnd]. No one other than the Sovereign itself can enforce the repayment of debt by the Sovereign Nation. That is, unless the country has willingly agreed to the arbitration over any discrepancies in the debt contract through a mediatary such as Foreign Court. However, even in such a scenario, the enforcement over the debt repayment by the Foreign Courts or other Arbitrary authority tends to be limited in capacity (Rahbari & Buiter, 2013, p.6). Countries generally do not like to default on the debts as a choice, as it becomes costly and difficult to borrow money after defaulting once. We must however, remember, that countries are not “subject to normal bankruptcy laws and have the potential to escape responsibility for debts without legal consequences.”[Sovnd]. Hatchondo et al (2007) give us various definitions for a sovereign default. From a legal viewpoint, they say, that a default is the failure to pay a scheduled debt beyond the time specified in the contract. (Hatchondo et al, 2007, pp.163-164). They go on to add that Credit-Rating Agencies believe that when a country offers a restructing of the loan, that has terms less beneficial than the original structure of the debt, to be a technical default. (Hatchondo et al, 2007, pp.163-164). However, it is widely believed that Sovereign Defaults are not all that common, and are normally followed by a huge economic crisis which has happened in the sovereign which defaults on its debts.[Sovnd]. A sovereign default is not always a total default or a disowning of a debt. [Hat07] p. 164. Most of these defaults are generally a ‘settlement’ in the form of restructurring of the loan whereby the defaulting nation negotiates with its creditors new terms of payment that involve a partial principal waiver, a lowering of interest payments and an extended timeline for repayment. (Hatchondo et al, 2007, p. 164). The first case of Sovereign default is believed to have happened in Ancient Greece (377 B.C). Over the years, a few other countries have defaulted on their debt. Some of them are: England (three defaults before 1600) France (eight between 1558 and 1788) China (1929 and 1939) Nigeria (5 times since 1960) Russia (1998) Argentina (2001). [Tho11] [See Appendix for more countries] Costs and Benefits of Sovereign Default Often, countries that render sovereign default are involved in a ‘won’t pay’ rather than a ‘can’t pay’ situation (Rahbari & Buiter, 2013). Rahbari and Buiter (2013) say that “Among the social costs of sovereign default are contagion and concentration risk, both within and outside the jurisdiction of the sovereign, and ‘rule of law externalities’” (Rahbari & Buiter, 2013 p.2). Default by a country has some associate Costs and Benefits, which can be outlined below. 1.1 Benefits of a Sovereign Default It is widely believed that once a Nation defaults on its debts, either completely or by restructuring a debt, its reputation and credit ratings are hurt considerable. Hence, there is little reason to keep repaying debts if, by an act of default or expropriating any FDI has already tarnished the reputation of the Country[Wri09]. Kehoe (1998), Rose and Spiegel 2009 believe that a governments actions in a particular region of the world generally reveals its overall intentions, which hurts it international relations globally (Tomz, 2009, p.6). By defaulting on a debt, the country does not need to pay back the principal or any interests accrued on such principal in totality. Hence, it is a direct benefit for the Nation. [Wri09]. Let us take a hypothetical example of any country that is required to pay back a debt on maturity. Cole (1991) says that Policymakers tend to default on such debt intentionally when the resource value is the maximum in the economy. Cole (1991) goes on to add that during an economic downturn, tax incomes of the government are considerably lower than a boom phase.[Wri09] These results in a fiscal deficit for the Government, and the policymakers are in dire need of resources to finance this fiscal deficit. The easiest way to do so is default on an external debt which places even more burden on the policymakers and by defaulting shifts the burden to the foreigners who lose out on the debt extended by them to the defaulting country[Wri09]. Defaulting, or restructuring, helps the defaulting nations, to get a partial waiver on the amount of funds borrowed or an increase in the repayment time. Jenkner & Lu (2014) have observed that “Studies have shown that markets may underpriced sub-national governments’ risk on the implicit assumption that these entities would be bailed out by their central government in case of financial difficulties. However, the question of whether sovereigns pay a premium on their own borrowing as a result of (implicitly or explicitly) guaranteeing sub-entities’ debt has been explored only little” they use the data available for Spain and surrounding regions from a period of Jan 2010 to June 2013 and prove their risk transfer hypothesis. They calculate that Spain’s “spread may have increased by around 70 basis points as a result of the central government’s support for fiscally distressed ‘comunidades autónomas.”[Jen14] Hence, it may increase consumption in the short-term. One can question that why don’t more countries default on debt more often? If there were no costs involved regarding Sovereign default, most Nations would default on borrowing and investments by foreign companies in the country and therefore be bereft of any future investments and borrowing. 1.2 Cost of a Sovereign Default: Sovereign Defaults have taken place through the course of Financial International history. However, the costs associated with these defaults generally motivate the owing country to pay back its debt. Some of the costs associated with Default are outlined as follows. (a) Cost of Debt: Some penalties may be imposed by outside creditors on the cost or nature for defaulting countries to borrow in the future. (Saporta et al, 2006, p.298). As mentioned earlier, default may increase short-term consumption, but it is at the expense of a declining consumption in the long-run. Moreover, defaulting generally causes a loss of confidence amongst the businesses in the country; this may lead to a bigger financial crisis, where production activity may fall even in the short term. Thus an attempt to increase spending through a default may prove to be unsuccessful. [Sap06]. (b) Penalty Costs: Defaulting countries may be deprived to borrow from external creditors in the future. Moreover, defaulting Nations, especially ones with a prior history of defaults tend to receive poor credit ratings from international organizations for the period 1979-2000 than the countries who had similar financial positions but chose not to default. [Rei08]. “For example, during the 1980s a few major international banks held most of the defaulted Latin following the Foreign Sovereign Immunity Act (1976) in the United States and the State Immunity Act (1978) in the United Kingdom, it became common practice for most governments to waive sovereign immunity on foreign loans and bond contracts. In practice, however, this only allows creditors to have access to the debtor’s assets held for “commercial activity” in the country where the debt contract was issued. Moreover, a country considering default could remove its assets held in the foreign jurisdiction before any default.” (Saporta et al, 2006 p. 298). In reality, short sighted policymakers in a country which defaults overlook the potential harms in the future by wanting to capitalize and reduce burden in the present. (c) Broader Financial Costs: The above-mentioned costs relate directly to the nation from an external point of view, and how externally the government may be impacted. However, larger repercussions can be felt in the domestic market itself by falling outputs and consumptions; loss in business confidence in the overall economy (Tomz, 2009). In the case of Mexico, for example, it was in Mexico’s interest to avoid a default as it kept trade going [Sil01]. Hence, it should be concluded that in order to “To avoid the costs of default, then, the country need not convince foreign creditors to lend; it only need to convince .financiers to accept deposits” (Tomz, 2009 p. 7). Bailouts A Bailout may be defined as the saving of an organization (Rescued) from a possible or actual bankruptcy, with the rescue being provided by an economic enterprise (Rescuer) (Officer, 2013). The rescued or the rescuer can be an individual, an enterprise or even Governments and Nations. In case of Governments, the bailouts generally come from either a large domestic financial institution (like the country’s Central Bank) or an external economic entity such as the International Monetary Fund (IMF) or other Countries. A country’s central bank is seen as a lender of the last resort. There role is related to the “prevention and mitigation of Financial Crisis” (Fischer, 1999 p. 86). Advantages of bailouts: There can be several advantages to a bailout, especially in the case of Governments. A bailout assures that the rescued Government survives the phase of an unfavorable economic situation. It avoids the collapse of the entire financial system, where if banks and domestic financial intuitions fail or become insolvent, the entire economy is rendered useless. It restores the flow of credit back into the economy (Todorova, 2009). Moreover, if a failure or bankruptcy is predicted and based on that, a bailout can be achieved; it stops the melting of moral confidence in the economy, which can make things even worse monetarily. When a huge international organization like IMF provides a bailout to the government, it restores FDI confidence in the country again. Moreover, domestic financial institutions also get buoyed (Rogoff, 2008). Disadvantages of bailouts The disadvantages of a bailout can be described in two categories: “Anticipated and Actual”. (Officer, 2013). Moreover, “IMF bailouts can lead to debtor moral hazard if the Fund’s commitment/bargaining power is limited.” (Bird, 2001). In the last few years, we have seen high risks in currency trading, balance of payments and several banking crises which has led to bailouts by the International Monetary Fund (IMF). Thus, it comes as no surprise that “The problem of moral hazard in international crisis lending has consequently become very prominent in policy and academic discussions” (Noy, 2006, p.65). Thus, we deduce that Anticipated bailouts promote moral-hazard behavior (Noy, 2006, p. 65). This moral hazard not only impacts the rescued nation, but also the rescuing institute. “Ennis and Malik (2005) develop a theoretical model of the effect of Too Big To Fail - TBTF policy on bank decision-making. The result is consistent with moral hazard: a known TBTF policy increases the probability of failure of the bank.” (Noy, 2006, pp. 64-65). Another disadvantage of bailouts could be the riders imposed by the rescuing institution for fiscal restricting. In the recent past, there has been a strong initiative taken by the international community to make changes in the way sovereign debts are being restructured. Sovereign defaults are not a recent phenomenon. However, the question to be asked is why is there so much hype to this problem all of a sudden? The answer lies in the Mexican Crisis (1994-1995), followed by the successive crises in the Asian region, Brazil as well as Argentina (Rahbari & Buiter, 2013). During these crises, it was noticed that there was an absence of a Robust Bank Resolution Tool in these countries, and these in these countries, the Systematically Important Financial Institutions (SIFI) started to fail, and required government intervention for bail outs and it resulted in Government Failures (Zhou et al, 2012). Conclusion Theoretically, Sovereign Default by a nation should be discouraging to a country through the fear of economic damage it would create. While countries do face some penal costs for a default, it seems these costs are short-term only. For Example, Argentina’s GDP fell by 10.9% after its default in Dec. 2001 (Nahón, 2013). This was when Argentina’s Debt was at 166% of its GDP. However, after a major debt restructuring by its creditors its GDP grew back and its debt being 45% in 2012 compared to its GDP. A similar case can be found for Uruguay, Russia and Indonesia. However, this does not mean that a default automatically results in a boom. A bailout rescues investor confidence and halts the decline in the insolvent country. A growth is seen after a default mainly because defaults happen in recessionary market situations, and the economy is expected to take an upward turn post such a crisis. However, it can also be noticed that in the case of many Caribbean and African Nations (Ex. Grenada and Cameroon) this was not the case as after defaulting, there were serious economic repercussions in the countries. Moreover, there runs a risk of some countries being carefree and ambitious in their fiscal policies and assuming that a bailout will come if they fail. A Bailout should have riders involved so that policymakers are not lax in their fiscal policies. Policymakers should not be lax when it comes to fiscal policies and preserving financial stability in the economy. A restructuring of debt is normally at the discretion of the creditor. Hence, when a debt is restructured, the country is also required to make changes to its fiscal policies which are at the risk of being exploited by foreigners. Mr. Christodoulou (head of Greece’s debt office) says other countries and financial institutions need to learn from Greece’s debt restructuring. He believes that “The system needs to be fixed,” he says. “We should have a predictable framework for restructurings that ensures that other countries do not have to go through what Greece did.” (Wigglesworth, 2014). References: Sovnd: , (Investopedia, n.d), Hat07: , (Hatchondo et al, 2007), Tho11: , (Mucha, 2011), Wri09: , (Tomz, 2009), Wri09: , (Tomz, 2009), Jen14: , (Jenkner & Lu, 2014), Sap06: , (Saporta et al, 2006), Rei08: , (Rogoff, 2008), Sil01: , (Boughton, 2001), The13: , (Economist, 2013), Appendix [The13] Read More