Real Economy Impact

Distributional Issues

Although it is often cloaked in technical language, sovereign debt restructuring is in fact a very politically-charged issue, inescapably wrapped up in deep-seated normative judgements about equity and the appropriate balance of public-private burden sharing during financial crises.

The accumulation of unsustainable debt by a government can raise questions of intergenerational equity (Buccheit and Gulati 2010). If a government borrows money to invest in the productive capacity of its economy, then that borrowing and investment will likely benefit future generations. The fact that such generations will have to manage and/or repay the debt that funded those productive investments is inconsequential, because the economy from which they draw their earnings (and tax revenue) will likely be larger and more vibrant as a result of the debt-financed investments made by previous governments. In contrast, governments can accumulate large amounts of debt for fundamentally unproductive purposes, such as to fund projects that serve narrow (special) interests or to ‘buy votes’ that help secure re-election for incumbent politicians. If future generations are left to service that debt, it is equivalent to a transfer of wealth from future generations to the present one, since only the current generation benefits from spending the money that future generations will have to repay. Intergenerational equity is thus one of the distributional issues tied-up in the broader issue of sovereign debt.

Intergenerational equity is not the only, nor the most contentious, distributional issue at the core of sovereign debt and sovereign debt restructuring. Inter-creditor equity is also a key concern for those seeking to resolve crises in a fair and efficient manner. Here, the main sources of tension lie in balancing the interests of short-term and long-term holders of sovereign debt, on one hand, and foreign and domestic creditors, on the other. Restructurings tend to affect only holders of a particular bond issuance or series, rather than all bondholders. Not being able to bind all bondholders across difference bond issuances to a common restructuring agreement is referred to as an aggregation problem. The practical implication of this problem is that not all creditors are treated equally. Typically, those whose claims are reaching maturity during a debt crisis or IMF program (often short-term claims) are forced to restructure (i.e., take a loss) while those with longer-term holdings retain the full value of their claims.

The nationality of bondholders – particularly, whether they are foreigners or domestic residents – can also be an important determinant in the differential treatment of creditors. For example, domestic and foreign creditors were treated differently in the last restructurings of Argentina, Jamaica, Dominica, Russia, and Uruguay, to name but a few cases. There are a number of reasons why sovereigns might want to discriminate for or against domestic creditors in their debt restructuring strategies (Erce 2013). First, residents are subject to the domestic legal and regulatory system, making them easier to persuade or coerce into participating in a debt exchange. Second, a sovereign may choose to honour its external debt obligations while restructuring its domestic ones in order to retain access to international capital markets – a particularly attractive strategy for states with underdeveloped domestic financial markets. Third, a sovereign may choose to restructure its external debt obligations while remaining current on its domestic ones in order to mitigate the domestic financial fallout that could result from defaulting on and/or restructuring claims held by local banks and businesses. Finally, domestic residents may have more influence than foreigners over their governments’ decision-making and thus a greater ability to shape outcomes that favour domestic creditors (Erce 2013). For these reasons, inter-creditor equity can be a contentious aspect of sovereign debt restructuring, with a direct impact on the perceived fairness and efficacy of various crisis resolution strategies.

There are also a number of distributional concerns that, in a simplified form, break down along public-private lines. For ideological and material reasons, many private sector representatives and free-market advocates oppose the creation of any regime or mechanism that would make it easier for governments to restructure their debts because sovereign debt restructuring represents a redistribution of capital from creditors, often private bondholders, to sovereign debtors. When a sovereign restructures its debt, it is ‘bailing-in’ its creditors by not repaying them in full and/or on time. This represents a financial loss for creditors and a relative gain for debtors.

On the other hand, sovereign debt crises often follow private sector financial crises because governments choose to bail-out insolvent financial firms at a time when recession-induced government expenditures, such as for unemployment insurance, are rising and tax revenues are falling. Thus, private losses that generate financial crises are often socialized and borne by the public sector, representing a large redistribution of pain from private financial actors to the population writ large. Furthermore, when the IMF and bilateral official creditors bail-out countries with sovereign debt problems, they are essentially bailing-out the sovereign’s private creditors. If the sovereign is not insolvent but rather illiquid, there is nothing necessarily wrong with the bail-out strategy, provided that it is properly formulated and executed. This strategy does, however, place responsibility for the crisis squarely on the borrower instead of the lender. This is problematic insofar as creditors that expect to be bailed-out in the event of a sovereign debt crisis have an incentive to lend in an excessive and imprudent manner to sovereigns. There is thus a compelling argument in favour of more burden-sharing between debtors and creditors during sovereign debt crises. When liquidity support (i.e., a bail-out) is coupled with a domestic adjustment program, usually involving painful austerity measures, this problem is made more acute. In this case, domestic populations – particularly those at the lower end of the income distribution who rely most heavily on social services – are forced to bear the brunt of the crisis, while international lenders escape unscathed. For many, this is a deeply unfair distribution of the costs and benefits of sovereign debt and sovereign debt crises.

Issues for Discussion

• What are the potential costs and benefits of reforming the international debt architecture? In a globalized financial system, are sovereign debt crises inevitable and bound to be costly, or are there certain types of reforms that could reduce the frequency and costliness of such crises?

• How can we best balance the different distributional concerns that arise from sovereign debt and sovereign debt restructuring?

• Are lenders and borrowers equally (or differentially) responsible for the buildup of unsustainable debt? What does that imply for burden-sharing in the resolution of sovereign debt crises?