Journal of Economic Literature 2009, 47:3, 651–698 http:www.aeaweb.org/articles.php?doi=10.1257/jel.47.3.651

The Economics and Law of Sovereign Debt and Default

Ugo Panizza, Federico Sturzenegger, and Jeromin Zettelmeyer*

This paper surveys the recent literature on sovereign debt and relates it to the evolu- tion of the legal principles underlying the sovereign debt market and the experience of the most recent debt crises and defaults. It finds limited support for theories that explain the feasibility of sovereign debt based on either external sanctions or exclu- sion from the international capital market and more support for explanations that emphasize domestic costs of default. The paper concludes that there remains a case for establishing institutions that reduce the cost of default but the design of such institutions is not a trivial task.

1. Introduction Reaccess to international capital markets following several of these crises appeared to he economic literature on sovereign be faster than in previous decades, challeng- Tdebt has enjoyed an explosive comeback ing the notion that capital market exclusion in recent years. After thriving in the 1980s, was the critical penalty that made sover- research on sovereign debt had gone out eign debt possible. At the same time, sev- of fashion in the second half of the 1990s; eral high-profile litigation cases appeared perhaps because the financial problems of to bring back the legal system as a possible developing countries seemed to have moved enforcement mechanism for sovereign debt elsewhere, toward privately issued debt and contracts. Finally, with securitized debt mar- liquidity crises. A new generation of sovereign kets, there now seemed to be room for sig- debt crises, beginning with Russia’s default nificant collective action problems in debt in August of 1998, returned sovereign debt restructuring negotiations, bringing cross- to center stage, challenged some old ideas, creditor problems to the fore along with and raised new questions. the traditional debtor–creditor relationship.

Nelson, Damien Eastman, Christoph Trebesch, Michael * Panizza: United Nations Conference on Trade Waibel, and Mark Wright as well as the editor, Roger and Development and the Graduate Institute, Geneva. Gordon, and four anonymous referees for helpful com- Sturzenegger: Universidad Torcuato di Tella and Banco ments and suggestions. Some portions of this article draw Ciudad. Zettelmeyer: International Monetary Fund and on Sturzenegger and Zettelmeyer (2007b) and Borensz- European Bank for Reconstruction and Development. tein and Panizza (forthcoming-a). The views expressed in We thank, without implication, Mackie Bahrami, Charlie this article are the authors’ only and need not reflect, and Blitzer, Eduardo Borensztein, Eugenio Cerutti, Olivier should not be represented as, the views of any of the insti- Jeanne, Thomas Laryea, Eduardo Levy Yeyati, Becky tutions that the authors are affiliated with.

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The worry that this might make debt crises (and assumptions) of the theoretical litera- unmanageable led to a far-reaching policy ture? Or do we need to change our views on debate, ­culminating in the 2001 proposal by what makes sovereign debt possible based on IMF First Deputy Managing Director Anne the new empirical work and the experience O. Krueger to create a new legal and insti- provided by the most recent crises? Second, tutional framework—“the sovereign debt have changes in legal doctrine and other legal restructuring mechanism”—for resolving innovations had an impact on the behavior of debt crises. The proposal fell through, but the sovereign debt market? And third, how it prompted significant changes (“collective has the resolution of debt crises evolved over action clauses”) in the template used by bond time, and what case, if any, remains for insti- contracts under New York law. tutional or policy changes that might improve The literature has since evolved in three the workings of the sovereign debt market main directions. First, a series of theoretical and reduce the cost of crises? contributions written since the beginning We proceed in four steps. Because a funda- of this decade give new answers to the old mental characteristic of sovereign debt is the question of how sovereign debt can exist at more limited legal enforcement compared to all in the absence of legal enforcement and corporate debt, we begin by reviewing the attempt to do a better job in matching the law of sovereign debt, including changes away stylized facts. Second, there has been new from “absolute” sovereign immunity that have theoretical interest in both debt structure— taken place in the last thirty years. These as short-term and foreign currency debt had changes have not always been appreciated by been blamed for some of the new crises—and economists due to divisions between the legal debt restructuring, touching, in particular, on and economic literatures. Second, we review the trade-off between ex post efficiency and the theoretical economic literature on sover- ex ante incentives. Third, and perhaps most eign debt. Because there are two comprehen- significantly, there has been an explosion in sive reviews of the traditional literature on the empirical literature. As recently as ten sovereign debt (Jonathan Eaton and Raquel years ago, there were relatively few empirical Fernandez 1995 and Kenneth M. Kletzer papers on why countries may want to repay, 1994), our review is brief, nontechnical, and making Anatole Kaletsky’s slim 1985 vol- focuses on the contributions written in the ume, The Costs of Default, a frequently cited last fifteen years. A review of the extensive source. In contrast, there have been more new empirical literature comes next. Finally, than two dozen contributions in this area we address the question of whether and how since about 2002. In addition to the costs of the cost of debt crises could be reduced, default, these papers explore when and why drawing on some new theoretical contribu- countries borrow, whether countries choose tions and on recent policy debates. to default in good or in bad times, how coun- tries and debtors restructure, how investors 2. The Law of Sovereign Debt have fared with sovereign debt during cri- ses and over longer periods, and the role of In the corporate world, debt contracts are domestic sovereign debt. enforced by the courts. A corporation cannot This paper surveys this literature, with a simply repudiate, i.e., decide not to repay its focus on the new empirical contributions. debts. If it tried, it would be sued and the We are particularly interested in three ques- courts would force it to hand over assets to tions. First, is the empirical evidence on sov- the creditor, restructure, or (in the limit) shut ereign debt consistent with the predictions down and liquidate its remaining assets. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 653

This enforcement mechanism is much more the extent that he could successfully make a limited in sovereign debt for two r­easons. case in the defaulting country’s courts). First, few sovereign assets (including future However, a more restrictive view of sover- income streams) are located in foreign juris- eign immunity began to take hold after the dictions, and a sovereign cannot credibly com- Second World War (Brownlie 2003, p. 325). mit to hand over assets within its borders in In the United States, the interpretation of the event of a default. Second, there are legal sovereign immunity began to change in the principles that protect sovereign assets even 1950s, in part as a consequence of the cold when they are located in foreign jurisdictions. war—the United States felt uneasy with However, the strength of this protection has granting sovereign immunity to Soviet Union declined over time, both through statutory state owned companies operating in the changes and through case law, opening a win- United States. The U.S. government encour- dow for legal enforcement. The question is aged a more restrictive theory of sovereign how wide this window is and whether it has immunity under which foreign sovereigns had an effect on the sovereign debt market. were denied immunity for commercial activi- We address the first of these questions in this ties carried on inside, or with direct effect section and the second in section 4. inside, the United States. This restrictive view was embodied in the Foreign Sovereign 2.1 Principles Protecting Sovereign Debtors Immunities Act (FSIA) of 1976, which allows Sovereign debtors have traditionally been private parties to sue a foreign government protected by the principle of (absolute) sover- in U.S. courts if the complaint relates to eign immunity, which states that sovereigns commercial activity. The United Kingdom cannot be sued in foreign courts without adopted similar legislation in 1978 and many their consent. The principle can be derived other jurisdictions have followed suit (Lee C. from the equality of sovereign nations under Buchheit 1986, 1995; Brownlie 2003). international law: legal persons of equal As a result, sovereigns can now often be standing cannot have their disputes settled held legally accountable for breach of com- in the courts of one of them (Ian Brownlie mercial contracts with foreign parties in the 2003). Importantly, however, immunity can same manner as private parties. This leaves be waived: a sovereign can enter in a contrac- open the question of what is a commercial tual relationship in which it voluntarily sub- transaction, and who is a sovereign, within mits to the authority of a foreign court in the the terms of a foreign sovereign immunity event of a dispute. law. With regard to the question of who is a Under absolute immunity, which was the sovereign, the U.S. FSIA, for example, defines prevailing doctrine in the nineteenth century a sovereign broadly to include agencies and and in the first half of the twentieth century, instrumentalities of a sovereign. Several court sovereign immunity applied even to commer- decisions have confirmed that the issuance cial transactions between foreign states and of sovereign bonds is a commercial activity. private individuals from another state. From Furthermore, a 1992 U.S. Supreme Court the perspective of governments, this had the decision (Republic of Argentina v. Weltover, advantage that private commercial interests see Philip J. Power 1996) established that did not get in the way of diplomatic and polit- suspending payments on debt contracts that ical relations. As a result, unless an aggrieved call for payment in the United States entails creditor could persuade his own government direct effects within the United States suf- to apply pressure, he was deprived of legal ficient to satisfy the U.S. nexus requirement remedies to enforce repayments (except to under the FSIA. Accordingly, under U.S. law, 654 Journal of Economic Literature, Vol. XLVII (September 2009) international bonds issued by a sovereign, legal protections afforded to the BIS against and a subsequent default, are almost always attachment proceedings. ­considered commercial activities, regard- In addition to sovereign immunity, two less of the purpose of the issue or the reason other legal principles or conventions have behind the payments interruption. Moreover, been invoked by sovereign debtors in resist- whatever protections of the sovereign remain ing creditor lawsuits during the 1980s and under U.S. law can be contractually waived, 1990s. The first of these legal principles is and such waivers are in fact routinely included the act of state doctrine, which states that in bond covenants. As a result, under U.S. courts should not judge the validity of a for- law (and that of several other major jurisdic- eign sovereign’s acts committed on its ter- tions), sovereign immunity no longer plays an ritory. “In contrast to sovereign immunity, important role in shielding sovereign debtors which acts as a jurisdictional bar to suits from creditor suits. against a sovereign, the act of state doctrine Sovereign immunity laws may be a more is a judicially created rule of abstention con- effective shield against attachment proceed- cerning the justiciability of the acts of for- ings, i.e., creditor attempts to collect once a eign governments” (Power 1996, p. 2732). favorable court judgment has been obtained. Unlike sovereign immunity, the act of state In particular, under FSIA and comparable defense cannot be contractually waived. laws, central bank assets—including inter- However, the doctrine has proved to be of national reserves—are typically immune little use to sovereigns for a similar reason as from attachment.1 For sovereign debt not sovereign immunity, namely, that defaulting issued by the central bank itself, this fol- on debtors payable in international jurisdic- lows from the fact that the central bank is tions is not considered to be a sovereign act generally viewed as a separate legal entity worthy of judicial deference (see Allied Bank that cannot be held liable for the acts of its International v. Banco Credito Agricola de principal (the sovereign). But even when the Cartago, discussed below). central bank itself is the debtor, most of its The second of these legal principles is assets—in particular, international reserves International comity, which, according to an and other assets necessary for the exercise 1895 U.S. Supreme Court decision, is defined of key central banking functions—gener- as “the recognition which one nation allows ally enjoy immunity, unless this is explicitly within its territory to the legislative, execu- waived (Paul Lee 2003; Ludwig Gramlich tive or judicial acts of another nation” (Hilton 1981). Moreover, a sovereign or a central v. Guyot, United States Reports, Vol. 154, p. bank can attempt to limit attachable assets 159). Although a “softer” principle than sover- by locating them outside the reach of for- eign immunity or act of state—Power (1996, eign courts. For example, government and p. 2738) describes it as “not the rule of law, central bank assets have been placed with but rather one of practice, convenience, and the Bank for International Settlements expediency”; Brownlie (2003, p. 28) speaks (BIS) in Switzerland to take cover under the of “neighborliness and mutual respect”— comity considerations have motivated several court decisions both against and in favor of the sovereign debtor, and continue to play a 1 The law on this matter is not entirely uniform, par- role today. In practice, comity considerations ticularly across European countries. As a result, sover- seem to have boiled down to a court assess- eigns have been concerned about attachment of central bank reserve assets in some European jurisdictions; see ment on whether a debtor’s actions could Manmohan Singh (2003). be viewed as broadly justified in light of Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 655

U.S. policies on how international debt cri- pursuant to Chapter 11 of our Bankruptcy ses ought to be resolved. As such, they have Code. On that basis, Costa Rica’s prohibition given the U.S. executive branch a lever for of payment of debt was not a repudiation of influencing debt-related disputes before U.S. the debt but rather was merely a deferral of courts. Thus, comity is an ­unreliable prin- payments while it attempted in good faith ciple, as “the defense’s likelihood of success to renegotiate its obligations” (Allied Bank is subject to reassessment with each shift in International v. Banco Credito Agricola U.S. policy on sovereign debt restructuring” de Cartago, 733F.2d23, 27, Second Circuit (Power 1996, p. 2741). 1984; cited in Power 1996, pp. 2739–40). Upon rehearing the case in March 1985, 2.2 Experience with Legal Enforcement of however, the court reversed itself after the Sovereign Debt Contracts U.S. Department of Justice argued that con- As we have seen, legal protections of sover- trary to the court’s initial assumptions, the eigns from court action by creditors were sig- U.S. government did not agree with “Costa nificantly reduced by the 1980s. The question Rica’s attempted unilateral restructuring,” is whether this has actually allowed creditors concluding that “while parties may agree to to extract repayment, or a favorable settle- renegotiate conditions of payment, the under- ment, from the sovereign debtor following lying obligations to pay nevertheless remain a default. To answer this, we briefly review valid and enforceable” (United States Court the experience with attempts by “holdout of Appeals for the Second Circuit, 1985. creditors” to enforce repayment through the Allied Bank International v. Banco Credito courts, focusing on a few landmark cases Agricola de Cartago, New York 757F.2d516). after the beginning of the 1980s debt crisis. This led to a settlement in which the U.S. The first such case was Allied Bank government encouraged Fidelity Union to International v. Banco Credito Agricola accept the package agreed by the rest of the de Cartago. In 1981, Costa Rica suspended bank syndicate (Christopher Greenwood and debt payments to a thirty-nine-member Hugh Mercer 1995). While Fidelity ultimately bank syndicate. A restructuring agreement did not obtain a better deal than the rest of was subsequently reached with all credi- the banks, the Allied Bank case nonetheless tors but one, Fidelity Union Trust of New demonstrated that a holdout creditor could be Jersey, which sued through an agent, Allied successful in the sense of obtaining a favor- Bank, in U.S. courts. A lower court initially able judgment, and showed that two impor- ruled in favor of Costa Rican banks that had tant legal principles—the act of state doctrine acted on behalf of Costa Rica, accepting the and international comity—did not necessarily defense’s argument that Costa Rica’s actions protect sovereigns in the event of defaults. were protected by the “act of state” doctrine. During the remainder of the 1980s, cred- In 1984, an appeals court disagreed with this itor litigation remained rare for two reasons. argument on the grounds that defaulting on First, there were strong mechanisms, both foreign debt did not constitute an act of state. contractually and through informal insti- However, it initially upheld the lower court tutions like the Bank Advisory Committee ruling on “comity” grounds, on the assump- process, which encouraged collective nego- tion that the U.S. executive branch was tiations with the debtor in resolving debt favorably disposed to Costa Rica’s attempt disputes and discouraged go-it-alone liti- to restructure its debts. “Costa Rica’s pro- gation. Second, prior to the creation of the hibition of payments of its external debt is secondary debt market in the late 1980s, analogous to the reorganization of a business virtually all holders of distressed debt were 656 Journal of Economic Literature, Vol. XLVII (September 2009) banks, which had a regulatory incentive 1994 (the settlement date of the Brady deal) against declaring a creditor in default (in and $25 million in cash covering accrued practice, a prerequisite for litigation), as this interest since April 1994. Hence, Brazil would have required them to write down treated the remaining MYDFA as if it had their loans. This situation began to change been performing since April of 1994, sig- in the late 1980s, as creditor banks provi- naling that it would continue ­servicing sioned against loan losses and began writing the loan in the future. On that basis, the off loans, and the creation of a secondary Darts managed to effectively sell their market in securitized loans allowed new MYDFA ­holding by issuing $1.28 billion investors—including specialized firms that in Eurobonds secured by MYDFA debt in became known as “distressed debt funds” October of 1996, at a ­modest spread over (or “vulture funds”)—to buy defaulted debt Brazilian sovereign debt with similar pay- at large discounts with the aim of extracting ment terms. Although the market value of the best possible settlement. this issue, at about $1.1 billion, fell short of These changes were soon followed by the $1.4 billion that the Darts had initially several high-profile lawsuits involving debt demanded, this meant that the Darts came purchased in the secondary markets. A par- out much better than creditors that had ticularly significant case pitted the Dart accepted the Brady exchange. family, which had accumulated $1.4 billion From a legal point of view, several aspects of defaulted Brazilian “Multi-Year Deposit of the CIBC case are notable. First, Brazil Facility Agreement” (MYDFA) debt at large did not invoke either sovereign immunity discounts, against the Central Bank of Brazil or the act of state doctrine in its defense, a (CIBC Bank and Trust Co. Ltd. v. Banco recognition of the fact that these principles Central do Brazil; see Power 1996 and John had lost their protective power in the context Nolan 2001). The MYDFA was long term of sovereign debt litigation. Instead, it tried debt, created in a 1988 debt restructuring to invoke two arguments designed specifi- agreement, which Brazil had stopped ser- cally to fend off holdouts that had purchased vicing in 1989. This debt was eventually distressed debt in the secondary market, exchanged for Brady bonds in a 1993 restruc- namely, that assignment of the debt to CIBC turing accepted by all creditors except the was invalid under the terms of the original Darts. In order to prevent the Darts from debt contract (in this case, the MYFDA), becoming the sole debt holder and thus gain and that the Darts’ suit violated New York’s the ability to accelerate outstanding principal “Law of Champerty,” which prohibits litigat- and interest payments, the Central Bank of ing on a claim purchased exclusively for the Brazil retained $1.6 billion of MYDFA debt. purposes of filing a law suit. Both arguments In response, the Darts (through CIBC as the were rejected by the court. The “Champerty debt holder of record) sued the Central Bank defense,” in particular, suffered from having of Brazil in New York, claiming: (1) past due to prove intent: claimholders could argue that interest under the MYDFA and (2) the right they had purchased the claim not with the to accelerate the entire principal and interest intention to litigate but in order to get paid, owed. In May 1995, the court ended up siding and that the decision to litigate was merely a with the plaintiff on the first claim, although reaction to the sovereign’s refusal to pay, and it declined to allow the Darts to accelerate. fully within their rights. In March of 1996, Brazil settled, paying Finally, as in the Allied Bank case, the the Darts $52 million in Eligible Interest U.S. government filed a brief, but with the Bonds covering past due interest until April opposite thrust, urging the court to reject Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 657 the Darts’ claim for acceleration of principal claim, and subsequently settled for close to on the grounds that holdouts that had pur- that amount, notwithstanding the fact that chased debt in the secondary market should it had acquired the Panamanian debt at a not be allowed to take a free ride on debt substantial discount from Panama’s original workouts agreed by a majority of creditors. creditors. Elliott could extract full repay- The United States observed that its concern ment because it was able to obtain attach- in CIBC was a “mirror image” of its concern ment orders that could have inflicted serious in Allied ten years earlier, with the con- harm on Panama: one directed against U.S. cern for creditor rights being trumped, in assets of the national telecommunications this case, by a concern that creditors would company which Panama was about to priva- use the courts to extract unfair concessions tize; and one which would have interfered from the debtor (Power 1996). The court with a large new bond issue in New York. ultimately agreed with the U.S. argument, Although Panama paid in full, the amount so comity may have benefited the debtor in paid ($71 million) was an order of magnitude this aspect of the case. smaller than both the value of the privatiza- By and large, the precedents set by CIBC tion deal and the proceeds received from the have been borne out in subsequent litiga- bond issue. tions. First, subsequent cases have con- The most famous legal victory of holdout firmed a holdout’s right to litigate on the creditors is Elliott Associates v. Banco de basis of a claim acquired in the secondary la Nación (Peru). Elliott acquired nonper- market. The Champerty defense, in par- forming debt guaranteed by the Peruvian ticular, was rejected in several instances, government, at a large discount, just prior including by the English Court of Appeal in to Peru’s 1996 Brady deal. After Peru Camdex International Limited v. Bank of refused to repay in full, Elliott sued in New Zambia, and—on appeal—by a New York York. A prejudgment attachment sought by court in Elliott Associates v. Banco de la Elliot was initially denied on the grounds Nación (Peru). Second, court judgments that it would have jeopardized the pend- generally paid some attention to the argu- ing Brady restructuring, but in late 1999, ment, made by the U.S. government in the Elliott obtained a prejudgment attachment CIBC case, that holdout creditors should not order against Peruvian assets used for com- be allowed to disrupt or free ride on debt mercial purposes in the United States, and restructuring agreements negotiated with a finally, in June 2000, a US$57 million judg- majority of creditors—most notably, in the ment against Peru. Based on this judgment, case of Argentina’s 2005 restructuring. Elliott sought court orders in New York This said, the desire to safeguard credi- and various European countries that would tor rights as defined by the debt contract has either attach Peruvian assets or bar Peru tended to prevail whenever there has been from paying interest on its Brady bonds. a conflict between these two principles. For It was eventually successful, convincing example, in Pravin Banker v. Banco Popular a Brussels appeals court to order the pay- del Peru, a New York court stayed Pravin’s ments provider Euroclear on an emergency claims for full repayment by Peru on two basis—i.e., before arguments in opposition occasions to avoid a disruption to the ongo- had been made—to suspend payments on ing Brady deal negotiations, but ultimately Brady bond interest payments. Faced with decided in favor of Pravin. Similarly, in an approaching payments deadline that Elliott Associates v. Republic of Panama, would have brought its entire stock of Brady Elliott obtained judgments covering the full debt into default, Peru decided to settle for 658 Journal of Economic Literature, Vol. XLVII (September 2009) a reported sum of US$56.3 million rather payments channeled through Euroclear, than continue the legal fight. since Euroclear was not a party to the con- The Elliott/Peru case caused alarm in tract in which the pari passu clause arose. In official policy circles because it appeared Kensington v. Republic of Congo, an English to hand holdout creditors an instrument to court also rejected enforcement based on the enforce claims against a debtor country at pari passu clause, on the grounds that ­reliance the expense of other (consenting) ­creditors. on this contractual clause was inconsistent Rather than engaging in the difficult pro- with the fact that the plaintiff’s claim had cess of attaching debtor assets abroad, been reduced to a court judgment. In Red holdouts could ask courts to interfere with Mountain Finance v. Democratic Republic ­cross-border payments to creditors that of Congo, the courts rejected the broad con- had previously agreed to a debt restructur- struction of the pari passu clause but issued ing, hence ­creating a seemingly formidable an injunction with a similar effect, i.e., pre- obstacle to orderly sovereign debt restruc- venting the debtor from making external debt turings. However, subsequent restructur- payments unless proportionate payment was ing cases did not bear out this fear, in part made to Red Mountain. The DRC appealed because the legal argument that Elliot used the injunction, but settled with Red Mountain to interfere with Peru’s debt service pay- at about 37 percent of the value of the judg- ments turned out to be weak,2 and in part ment claim before the appeal hearing, just because steps could be taken to protect ahead of an arrears-clearing payment to the international payments from holdouts. Most International Monetary Fund that reestab- obviously, payments could be made in the lished Congo’s access to multilateral financial debtor country, so that any cross-border support after years of crisis and civil war. transfer would involve creditor accounts The final installment of our brief review only, and international payments systems is the extensive litigation associated with could be explicitly protected from judg- Argentina’s 2001 default. By late 2004, almost ment creditors through changes in national 140 law suits—including fifteen class action laws (Belgium adopted such a law after the suits, a novel vehicle in the context of sover- Elliott case). eign debt litigation—had been filed against Several holdouts attempted to mimic Argentina in New York, Italy, and Germany, Elliott’s legal strategy with respect to Peru, both by distressed debt funds ­holding with limited success (Singh 2003; ­Inter- Argentine claims and “retail investors.”3 national Monetary Fund 2004). In LNC v. Many of these suits resulted in judgments in Nicaragua, the Belgian Court of Appeals favor of the creditors, including a $725 mil- found that the contractual pari passu lion judgment in favor of one creditor (EML, clause did not give LNC the right to attach ­ a subsidiary of Dart Capital).

priority­ than other unsecured claims (G. Mitu Gulati and- 2 Elliott’s motion to suspend payments to Peru’s Brady Kenneth N. Klee 2001; Philip Wood 2003; Buchheit and bond holders rested on a broad interpretation of the pari Jeremiah S. Pam 2004). By now, Elliott’s interpretation passu clause in the debt contracts it had purchased, as giv- of the pari passu clause has been challenged not just by ing it the right to receive a proportional share of any pay- many legal commentators but also (in the context of the ments on external debt made by Peru (though arguably Argentina case, see below) by the U.S. government, the the Brussels court went further, effectively giving Elliott Federal Reserve Bank of New York, and the New York priority over the Brady bond holders). This contrasts with Clearing House Association. a more conventional interpretation of the pari passu clause 3 In addition, a large number of suits has been filed in stating that the claim in question does not have lower Argentine courts. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 659

However, attempts to actually attach In sum, changes in the legal environment assets turned out to be fruitless.4 So were since the late 1970s have made it much eas- attempts to block Argentina’s January 2005 ier for holdout creditors to obtain judgment debt exchange offer from going forward. claims. In addition, there are some exam- These were followed by a further legal chal- ples—most famously, CIBC/Brazil, Elliott/ lenge in March 2005, shortly before the Panama, and Elliott/Peru—in which hold- exchange was to settle, NML Capital (an outs have been able to enforce those claims, offshore fund with ties to Elliott Associates) or settle at substantially better terms than the asked a New York court to attach a portion average creditor. These settlements seem to ($7 billion) of Argentina’s defaulted bonds have occurred either because holdouts were that had been turned in by consenting bond- able to credibly threaten to attach sovereign holders to the Bank of New York, in charge assets or interfere with international transac- of carrying out the exchange, arguing that tions, or because of reputational concerns— they had market value and, hence, could be debtor reluctance to defy court judgments sold to satisfy a future judgment. The court at a time when they were regularizing their rejected this argument on the grounds that, record as borrowers. This said, full repay- until settlement, the bonds belonged to the ment has remained the exception, and many creditors that had accepted the exchange, holdouts have received nothing (Federico and that attaching them would jeopardize Sturzenegger and Jeromin Zettelmeyer the exchange. In late May, an appeals court 2007b). Furthermore, attempts to block debt upheld this decision, arguing that the lower restructuring negotiations or debt exchanges court “acted within its discretionary author- through litigation have not been successful. ity to vacate the remedies in order to avoid a substantial risk to the successful conclusion of the debt restructuring. That restructur- 3. The Economic Theory of ing is obviously of critical importance to the Sovereign Debt economic health of a nation” (United States Court of Appeals for the Second Circuit, As we have seen in the previous section, 2005. EM Ltd. et al. v. The Republic of the main difference between corporate and Argentina, summary order, May 23, 2005, sovereign debt is the lack of a straightforward New York, p. 3). Although the court techni- legal mechanism to enforce repayment of the cally did not set a precedent because it did latter. In the event of default, legal penalties not rule on the legal issues disputed by the or remedies do exist, but they are much more parties, one has to agree with Anna Gelpern’s limited than at the corporate level. This leads (2005, p. 5) observation that “if future to the question of why debt nonetheless tends judges use similar reasoning, pre-closing to be repaid, and why a sovereign debt market challenges look increasingly remote.” can exist. Much of the economic literature on sovereign debt has focused on this problem. The most radical way of posing the question is to ask whether there would be a ­sovereign 4 For example, plaintiffs sought to attach the represen- debt market if creditors had no direct power tation office of the province of Buenos Aires in New York, diplomatic facilities, U.S. accounts of Correo Argentino to enforce repayment ­whatsoever, and S.A. (the renationalized postal service), and—most signifi- their only means of retaliating in the event cantly—$105 million in reserves held by the Central Bank of default would be through the denial of of Argentina in New York. All these requests have been denied (the latter on appeal by the U.S. Supreme Court in future credit. In a seminal paper, Eaton and October 2007). Mark Gersovitz (1981) showed that under 660 Journal of Economic Literature, Vol. XLVII (September 2009) some assumptions, the answer can be “yes.” The second line of criticism, due to Jeremy If debtors have no way of insuring against Bulow and Kenneth S. Rogoff (1989b), output shocks other than through borrow- focused on the implicit assumption that ing, and default triggers permanent exclusion borrowing from international lenders is the from credit markets, then the threat of losing only way in which countries can smooth con- access to credit markets is a sufficient rea- sumption in response to shocks to output.7 son for repaying, up to a certain maximum What if there are other ways, including stor- level. This level is higher, the bigger the vari- ing output, purchasing insurance, or invest- ance of output, and the more the borrow- ing a portion of one’s wealth abroad so that ing country values the insurance function of it can be tapped in times of need? Clearly, ­international capital markets for given fluc- this would diminish the dependence on tuations in output.5 international credit for insurance purposes, Though highly influential, Eaton and and thus the effectiveness of exclusion from Gersovitz’s result was quickly criticized from credit markets in preventing defaults. In the two angles. The first, anticipated by Eaton limit, if a country can purchase an insurance and Gersovitz themselves in the introduc- contract that delivers payments in low out- tion of their paper, focused on the assump- put states exactly like borrowing would, then tion that a default could be punished through the threat of exclusion from credit loses its permanent exclusion from future credit. bite entirely. To see this, suppose sovereign The problem is that in such a situation both debt could exist in these circumstances, and ­parties—creditors and debtors—are gener- take the highest level of debt that can sup- ally worse off than in a situation in which posedly be sustained. Rather than repay- lending resumes.6 In technical parlance, a ing this debt to creditors, the country could lending equilibrium sustained by the threat use the repayment to collateralize an insur- of a permanent embargo on future lending ance contract delivering the same maximum is not renegotiation-proof, in the sense that transfer in bad states as the country could after a default both parties potentially ben- have borrowed under the previous debt efit from reaching a new agreement involving contract, in exchange for country payments positive lending. But if such an agreement (“premia”) in good states. Thus, a “cash-in- is anticipated, then this undermines the advance” insurance contract can be designed expected punishment that was sustaining so that it exactly replicates the flows associ- positive lending in the first place (see Kletzer ated with international borrowing. But in 1994 for details). addition, the country would receive interest

acceleration­ of capital accumulation—these can generally 5 In Eaton and Gersovitz’s model, the insurance not be exploited to enforce repayment (Eaton, Gersovitz, motive comes through concavity in the utility function, and Joseph E. Stiglitz 1986). The reason is that they imply i.e., risk aversion (the country prefers smooth consump- a point in time after which the motive for borrowing dis- tion to choppy consumption). This is the way in which appears (for example, because the capital stock has been international borrowing has usually been motivated in built up to the point where the marginal return to capital the literature, but it is not the only way. For example, one equals the international interest rate). Anticipating that could assume linear utilities and concavity in production, point, creditors will refuse new lending, which takes away together with the assumption that production requires the incentive to repay in the preceding period, and so on capital (Harold L. Cole and Patrick J. Kehoe 1998; Mark by backward induction. L. J. Wright 2005). What these stories have in common 6 In addition, there is little empirical justification for is that they generate potential gains from trade between this assumption (see below). borrowers and lenders that go on forever. While there 7 We would like to thank an anonymous referee for may be other motives for borrowing that do not have reminding us that this criticism had also been anticipated this ­property—for example, impatience to consume or by Eaton and Gersovitz (1981). Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 661 on its collateral. Since this argument can be a default in the credit market. Most of these made for any level of debt, any borrowing is papers no longer rely on enforcement through impossible. the (implausible) threat of permanent exclu- Together, these objections posed a pow- sion from credit markets, and some explicitly erful challenge to the notion that the threat address the renegotiation problem. of exclusion from credit markets, by itself, One group of papers (including Cole and makes sovereign borrowing possible. Broadly Kehoe 1995, Eaton 1996, and Kletzer and speaking, the literature has since evolved in Brian D. Wright 2000) sidestep the Bulow three directions. and Rogoff (1989b) critique by dropping the A first group of papers, including Jeffrey assumption that the government can safely Sachs and Daniel Cohen (1982), Bulow and invest abroad regardless of their past behav- Rogoff (1989a), and Fernandez and Robert ior. Just like the debtor countries them- W. Rosenthal (1990), focused on direct pun- selves, financial institutions may not be able ishments as the reason for repayment. Direct to commit to future payments, at least not punishments are generally interpreted as to countries that have defaulted (for exam- interference with a country’s current trans- ple, because past lenders could attempt to actions, i.e., trade and payments, either interfere with such payments as a way of through seizure outside the country’s bor- enforcing their claims). In the jargon of this ders or through the denial of trade credit. ­literature, the “one-sided commitment prob- Renegotiations are explicitly modeled in lem” assumed by the sovereign debt litera- these papers. In Bulow and Rogoff (1989a), ture of the 1980s is replaced by a “two-sided contracts can be renegotiated at any time. commitment problem.” This said, with mul- The amount that a country can borrow is tiple lenders, an equilibrium sustained by determined by the proportion of the debtor’s credit market sanctions could still unravel output that creditors can expect to extract if a new lender refuses to participate in the in this renegotiation. The fact that creditors sanctions. In Kletzer and Wright’s (2000) can extract anything at all hinges critically on model, this is deterred by the original lend- the assumption that inflicting a sanction not er’s offer to “pardon” the debtor (i.e., to let only harms the debtor but also benefits the the debtor return to the original lending creditor directly (for example, the creditor relationship) in exchange for defaulting on receives a share of the debtor country’s trade any new lender. As a result, potential new payments). Thus, the threat that in the event lenders will respect the punishment of the of nonpayment creditors will actually impose borrower in equilibrium, i.e., a defaulter the sanction is credible. This, however, would will not be able to find new positive surplus not be the case if imposing the sanction ends lending relationships. up hurting both debtors and creditors. 8 More recently, several papers have dem- A second line of research attempts to res- onstrated that sovereign lending could cue the idea that governments repay because exist in a setting that both considers credit they are worried about the repercussions of ­market punishments only and assumes that

impact of trade sanctions and shows that trade disruptions 8 The appendix of Bulow and Rogoff (1989a) correctly of about 9 percent of the total value of imports and exports points out that creditors’ rights are now stronger than would be more costly than making payments of 5 percent what they were before the approval of the FSIA. However, of total external debt. However, as Bulow and Rogoff the discussion in section 2 above suggests that creditors point out, the fact that creditors can punish the defaulting have not been so successful in enforcing their claims. country does not necessarily imply that they will have an The appendix of Bulow and Rogoff (1989a) discusses the incentive to impose such sanctions. 662 Journal of Economic Literature, Vol. XLVII (September 2009) deposit or insurance contracts á la Bulow– the equilibrium in the subgame following a Rogoff are feasible. Wright (2002) shows default is just as unpleasant for the debtor as that sovereign debt can be sustained in a permanent lending embargo, but it is also these circumstances if countries can have efficient. The creditor appropriates all gains lending relationships with more than one from trade and would, thus, not want to rene- bank at a time—syndicated lending, which gotiate. For example, Wright (2002) builds a offers banks a profit relative to competitive model in which a country borrows from a sin- lending—because this creates an incentive gle bank that can commit to honoring deposit for lenders to ­collude in punishing default. and insurance contracts. The threat that Banks that defect by engaging in finan- enforces repayment is the replacement of the cial relationships with a defaulting coun- lending relationship with an insurance con- try are punished by exclusion from future tract in which the insurance “premium” after ­syndicated lending.9 Manuel Amador (2003) a default is so large as to leave the ­country presents a model in which governments without any surplus relative to permanent undersave because they know that they may exclusion from capital markets.11 lose power, but at the same time wish to A third line of research is built around the retain access to capital markets since they idea that incentives to repay sovereign debt count on returning to power eventually (this are created not so much through the threat fits a situation in which several established of punishment by creditors (whether directly parties alternate in power). This combina- or through the credit market) but rather tion—a desire for insurance ­combined with because defaults inflict broad “collateral a chronic lack of cash that could be used to damage” on the debtor country government make a deposit or finance a cash-in-advance or its economy. One way in which this could insurance contract—means that the threat of happen is if defaults have broader adverse exclusion from future borrowing is sufficient effects on a borrower’s reputation than just to sustain sovereign lending.10 through its standing in international credit As far as the enforcement of repayment markets. This was first raised as a possi- is concerned, Kletzer and Wright (2000) bility by Bulow and Rogoff (1989b) and is and Wright (2002) work with infinite hori- developed by Cole and Kehoe (1998). Cole zon models in which default does not trigger and Kehoe assume that there are two types permanent exclusion from credit markets, of debtor country governments: “honest” but rather a new financial relationship at terms that make the defaulting debtor no better off than permanent exclusion. Thus, 11 Perhaps because authors such as Kletzer and Wright (2000), Wright (2002), and Amador (2003) argue that the Bulow–Rogoff critique could in principle be overcome, an even more recent generation of sovereign debt mod- 9 Alternatively, the presence of multiple borrowers els has gone back to Eaton and Gersovitz’s (1981) implicit and lenders may sustain a collusive behavior in which assumption that countries do not have a savings oppor- individual banks will abstain from lending to borrowers tunity after defaulting (Mark Aguiar and Gita Gopinath that default on other banks. Banks that defect from this 2006; Cristina Arellano 2008; Irani Arráiz 2006b; cooperative arrangement can be punished by offering David Benjamin and Wright 2008; Ran Bi 2008a; Rohan the defector’s debtor a new contract that will induce it to Pitchford and Wright 2007; Vivian Z. Yue 2006). These default on its outstanding debt. models are not primarily interested in explaining the exis- 10 See Faruk Gul and Wolfgang Pesendorfer (2004) for tence of sovereign debt but in matching certain stylized a result that relies on the same intuition—namely, that facts (for example, that defaults occur in bad times or that saving cannot replace borrowing for consumption smooth- borrowing spreads are countercyclical) and, in some cases, ing purposes if the debtor has a self-control problem—but in endogenizing default penalties and explicitly modeling involves a different characterization of the self-control the debt renegotiation process. We discuss these issues in problem. sections 4 and 5. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 663

­governments that always repay, and “normal” other agents that change their behavior after governments which sometimes do not repay. observing a default. Lenders do not know the borrower’s type.12 If A related approach focuses on the infor- the government can save or purchase insur- mation content of default with respect to the ance and is in just one repeated relationship underlying structure of the economy (Guido (with lenders), then the Bulow–Rogoff result Sandleris 2005; Luis Catão and Sandeep applies, i.e., no borrowing can be sustained Kapur 2006; Kapur, Ana Fostel, and Catão if the lending relationship is sufficiently long 2007). For example, a default may signal that so that lenders find out about the “normal” credit conditions are tighter than expected, government’s true type.13 that the government’s financial position is Suppose, however, that there is another weaker than previously thought (thus lead- relationship in which the government’s part- ing to a revision on expected taxation) or ners (say, workers) also have incomplete that future output is likely to be lower than information about the government’s true expected. Regardless of the reason, these type. Both workers and lenders make infer- models predict capital outflows, reduction in ences about the government’s true type from investments, and potentially financial crises the way the government behaves in the other following defaults. relationship as well as in their own. Default, An alternative way to model the domestic vis-à-vis lenders, tarnishes the government’s costs of a sovereign default is to assume that reputation with its workers. This provides a a default limits the ability of private agents to powerful new incentive to repay. The intu- obtain the working capital necessary to buy ition is that while the possibility of saving the imported inputs (perhaps because the sover- defaulted debt or using it to back an insur- eign will impose capital controls or use other ance contract removes the need to preserve measures that will affect the ability of private a good reputation vis-à-vis the creditors, it is agents to make payments to foreign creditors). no substitute for preserving a good reputation In this case, the default will lead to an ineffi- in the other relationship. In that relationship, cient reallocation of labor and have a negative there is no mechanism analogous to the pres- effect on total factor productivity. Enrique G. ence of insurance contracts that would undo Mendoza and Yue (2008) show that a model the damage caused by the government’s loss with these characteristics is consistent with of reputation. The same argument could be the rapid output collapses and rapid recov- made for other relationships—for example, eries often observed around default episodes with depositors or foreign equity holders. and with the presence of a negative correlation What deters default in this class of models between sovereign spreads and GDP growth. is not the actions of the creditors, but of Moreover, the model can produce levels of sustainable sovereign debt that are closer to reality than those produced by standard mod- 12 A similar information problem is assumed in Eaton els á la Eaton and Gersovitz (see below). (1996). In his model, which assumes that borrowers can- not save or buy insurance, defaults lead to either exclusion Finally, Fernando Broner, Alberto Martin, from credit markets or higher interest rates, depending on and Jaume Ventura (2006) highlight the role whether in addition there is extraneous uncertainty or not of secondary markets in limiting or even about the borrower’s ability to pay. 14 13 If cash-in-advance contracts are possible, then “nor- eliminating sovereign risk. If governments mal” governments will be tempted to occasionally default and save. If this goes on for sufficiently long time periods, lenders will eventually become convinced that the gov- 14 Broner, Martin, and Ventura’s model focuses on debt ernment is indeed “normal.” In the limit for T , no contracts between private parties that are enforced (or → ∞ borrowing can be sustained. not) by a sovereign. 664 Journal of Economic Literature, Vol. XLVII (September 2009) maximize the utility of domestic residents ­borrow in bad times and repay in good times). and cannot discriminate between foreign Next, we look at the determinants of sover- and domestic debt holders, and foreigners eign default and discuss whether countries can sell debt to domestic residents in second- default strategically—i.e., when they could ary markets, then debt will always be repaid, easily repay their debt—or whether defaults even in the absence of any of the traditional are associated with inability to pay. In sec- punishments. If domestic agents could coor- tion 4.3, we examine how debt renegotia- dinate not to buy back the debt from foreign tions have changed over time, and whether creditors, the country would default and be or not they have become more difficult as a better off. The inability to coordinate leads result of collective action problems. We then to an ex post inefficiency but—by solving the move to the core question of how defaults sovereign-risk problem—allows the country are costly to the debtor country, and examine to borrow and hence is efficient ex ante. whether the various channels emphasized in Summing up, the classic theory of sover- the theoretical literature are consistent with eign debt focuses on the actions of non-res- the evidence. idents and suggests that incentives to repay 4.1 When Do Countries Borrow? sovereign debt might include a loss of reputa- tion in the international credit market, trade According to most of the models surveyed retaliations, and legal harassment. More in section 3, the main reason for issuing sov- recent models focus more on the domestic ereign debt is to smooth consumption by effects of the defaults. In this case, incentives transferring income from good to bad states to repay come from the concern that defaults of the world. Hence, sovereign borrowing may have direct adverse effects on domestic should be countercyclical. This conclusion is agents that the government is trying to pro- also in line with both traditional Keynesian tect, or that defaults could be interpreted as policies and neoclassical models of optimal bad news about either the sovereign or the fiscal policy (Robert J. Barro 1979). However, economy. The latter may in turn lead defaults a large literature beginning with Michael to spill over into a much broader range of Gavin and Roberto Perotti (1997) has shown economic problems. that developing countries have in fact tended to follow a procyclical fiscal policy.15 Is this 4. Empirical Evidence on Sovereign Debt also true for sovereign borrowing? Eduardo and Sovereign Default Levy-Yeyati (forthcoming) tackles this issue by regressing net transfers to developing We now survey the empirical evidence on countries from different types of creditors sovereign debt and default, discuss whether over the recipient’s output gap. His main the data can help us in discriminating among finding is that private lending to sovereigns is the models discussed in section 3, and check procyclical (the output gap coefficient is posi- if there are changes in the behavior of the tive and statistically significant) while official sovereign debt market and/or the resolution lending is countercyclical; with a net procy- of sovereign debt crises that could be attrib- clical effect in emerging market countries uted to the evolution of the legal doctrine as that regularly access private capital markets. discussed in section 2. We begin by discuss- ing the evidence on the cyclical properties of sovereign borrowing in light of the fact 15 See also Graciela L. Kaminsky, Carmen M. Reinhart, and Carlos A. Végh (2005). Roberto Rigobon (2005) and that the majority of theoretical models pre- Dany Jaimovich and Ugo Panizza (2007) provide a criti- dict countercyclical net debt flows ­countries( cism to the procyclicality literature. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 665

Table 1 Cyclicality of Sovereign Lending to Emerging Market Countries

(1) (2) (3)

Private Flows Offical Flows Total Flows FIXED EFFECTS ESTIMATIONS Output gap 3.790*** 0.284 4.074*** (0.57) (0.41) (0.71) IV FIXED EFFECTS ESTIMATIONS Output gap 3.777 2.373 6.150* (2.88) (2.16) (3.65) Observations 943 943 943 Number of countries 29 29 29

Notes: The dependent variables measure net transfer to the sovereign from private and official creditors scaled by the recipient’s GDP. The output gap is measured as the percentage deviation from a log-linear trend, all regressions include a constant term, country and year fixed effects. The instrument in the IV esti- mations is the weighted average of the output gap of the country’s trading partners. The data consists of an unbalanced panel covering the 1970–2006 period. The emerging market sample consists of the thirty-two countries included in the broadest JP Morgan EMBI Index. However, we exclude Ecuador and Lebanon because they are large outliers and Serbia for lack of data. Robust standard errors in parentheses. * p 0.1 < *** p 0.01 <

This evidence is, hence, inconsistent with the and in column 3 total net transfers. The top idea that countries borrow abroad to smooth panel of the table reproduces Levy-Yeyati’s income shocks. main results (we loosely define output gap Levy-Yeyati (forthcoming) does not deal as the percentage deviation of actual out- with reverse causality; that is, the possibility put from trend output). The bottom panel that sovereign borrowing may lead to higher of the table instruments the output gap with output and, hence, induce the observed a weighed average of the output gap of the positive correlation.16 Table 1 addresses this recipient country’s trading partners (see issue. In column 1, the dependent variable Jaimovich and Panizza 2007 for a discussion measures net transfers from private lenders of the properties of this instrument). It shows to emerging market sovereigns; in column 2, that controlling for endogeneity strengthens official (bilateral and multilateral) transfers; the procyclicality result.17

16 Levy-Yeyati (forthcoming) argues that reverse cau- sality is not an issue for his purposes because the insur- 17 In column 1, the coefficient is not statistically signifi- ance models of external borrowing predict that net flows cant but the point estimate is basically identical to the one should be countercyclical even after the effect of net bor- obtained in the standard fixed effects estimates. All of the rowing on output is factored in. other coefficients are larger in the IV estimates. 666 Journal of Economic Literature, Vol. XLVII (September 2009)

Table 2 Cyclicality of Net Lending Minus Reserve Accumulation

(1) (2) (3)

Private Flows – ∆Reserves Official Flows –∆ Reserves Total Flows – ∆Reserves

Output gap 3.345** 1.111 3.997** (1.57) (1.58) (1.68) Observations 931 931 931 Number of countries 29 29 29

Notes: The dependent variables measure net transfer to the sovereign from private and official creditors scaled by the recipient’s GDP minus reserve accumulation. The output gap is measured as the percentage deviation from a log-linear trend, all regressions include a constant term, country and year fixed effects. The data consists of an unbalanced panel covering the 1970–2006 period. The emerging market sample consists of the thirty-two countries included in the broadest JP Morgan EMBI Index. However, we exclude Ecuador and Lebanon because they are large outliers and Serbia for lack of data. Robust standard errors in parentheses. ** p 0.05 <

Why is sovereign borrowing procyclical? and Végh 2005) or from the presence of To answer this question, one can look at the corrupt politicians (Alberto Alesina, Filipe literature on the cyclical behavior of fiscal R. Campante, and Guido Tabellini 2008). policy. Here, there are two competing (but One can try to discriminate these two not n­ecessarily mutually exclusive) theo- classes of explanations by examining the ries for fiscal procyclicality. The first class joint behavior of net transfers and the accu- of explanations focuses on a market failure. mulation of international reserves. If net In particular, Gavin and Perotti’s (1997) transfers are procyclical because developing original contribution argued that procycli- countries cannot borrow during bad times, cality is driven by the fact that developing developing countries should find it optimal countries lack access to international credit to accumulate international reserves during during recessions.18 An alternative class of good times and run them down in bad times. explanations concentrates on political fail- Hence, if the market imperfection story is ures and shows that procyclicality may arise true we should find that net transfers minus from the presence of a conflict across dif- reserve accumulation are less procyclical ferent interest groups (Aaron Tornell and than net transfers. However, table 2 shows Philip R. Lane 1999), from political pres- that, when we subtract reserve accumula- sure for wasteful spending, (Ernesto Talvi tion from net transfers, the coefficients in a regression of this aggregate on the output gap are basically identical to those of the top 18 The role of incomplete markets is also emphasized by Alvaro Riascos and Végh (2003) and Ricardo J. Caballero panel of table 1. This provides prima facie and Arvind Krishnamurthy (2004). evidence that, in this sample of emerging Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 667 countries, political imperfections dominate output shocks can result in a situation in which market imperfections as an explanation for the country borrows up to its credit limit. If procyclical borrowing.19 the next output realization is bad again, the A third class of explanations for the country may prefer to default rather than to observed procyclicality of sovereign borrow- adjust consumption downward at a time when ing relates to the nature of the output shock. this is particularly painful.22 In fact, models Aguiar and Gopinath (2006) and Jean- that assume persistent shocks (Aguiar and Charles Rochet (2006) show that a model Gopinath 2006 and Rochet 2006) yield the with persistent shocks can generate procycli- clear prediction that defaults are countercycli- cal borrowing even in the absence of political cal: they tend to occur in bad times. 23 or capital market imperfections.20 To the best The evidence seems to be broadly con- of our knowledge there exists no empirical sistent with this aspect of the theory. Levy- test of whether the nature of the output shock Yeyati and Panizza (2006) use quarterly data is associated with the cyclicality of sovereign to study the evolution of GDP growth around borrowing. twenty-three default episodes that took place between 1982 and 2003 and find that 4.2 When Do Countries Default? defaults tend to follow output contractions. Michael Tomz and Wright (2007), using a In standard sovereign debt models, coun- much larger number of sovereign default tries borrow during bad times and repay dur- episodes between 1820 and 2004, also find ing good times. Countries might be tempted a negative correlation between output and to default rather than to repay, but antici- defaults. However, traditional sovereign debt pating this, creditors will not lend beyond a models have trouble explaining actual default threshold level of debt at which defaulting patterns along two dimensions. and facing financial autarky is preferable to First, they tend to greatly underpredict the repaying. As a result, in the simplest models, incidence of defaults. Aguiar and Gopinath defaults never happen. This said, defaults can (2006) calibrate a model assuming ­transitory arise in equilibrium in sovereign debt models shocks around stable trend growth using if the models incorporate uncertainty about Argentina’s business cycle statistics and a set output and the debt market is characterized of standard assumptions on the output and by incomplete contracts.21 A sequence of bad reputational cost of default. While Argentina defaulted or restructured its debt five times over the last two centuries, the calibrated model 19 Market imperfections may still play a role if they not of Aguiar and Gopinath (2006) ­predicts two only constrain borrowing in bad times but also discour- defaults in a period of 2,500 years. Aguiar and age the accumulation of reserves in normal times (for example, because international reserves are remunerated well below the opportunity cost of funds). Even with this caveat, the results of table 1 are hard to reconcile with the 22 In the presence of complete contracts, the govern- idea that the only reason for procyclical borrowing is lack ment could issue fully contingent debt or buy other forms of access during bad times. of insurance and become fully isolated from output shocks 20 The nature of the shock also plays a role in deter- (in other words, debt would mimic an equity contract). mining the relationship between output volatility and the We would like to thank an anonymous referee for remind- level of debt. Models with transitory output shocks predict ing us that defaults require both output uncertainty and a positive relationship between volatility and the level of incomplete contracts. sustainable debt. Models that assume persistent shocks 23 See also Juan Carlos Hatchondo, Leonardo Martinez, (i.e., shocks to trend growth) may generate the opposite and Horacio Sapriza (2007b), who show that capital mar- relationship. ket exclusion is not necessary for building a model that 21 The classic Eaton–Gersovitz paper contains such an matches the cyclical behavior of sovereign debt and sov- extension (see sections 2 and 3 of that paper). ereign default. 668 Journal of Economic Literature, Vol. XLVII (September 2009)

Gopinath (2006) show that by assuming shocks Default episodes do in fact tend to happen to trend growth it is possible to generate more in clusters, typically following the end of a reasonable default probabilities, and Hatchondo period of rapid credit expansion to the borrow- and Martinez (2008) show that a model with ing countries (figure 1).24 Hence, the evidence long-duration bonds also generates higher supports the idea that, in addition to debtor default probabilities. However, both papers country shocks (both economic and politi- yield default probabilities that are much lower cal), defaults are influenced by the behavior than those observed in the real world. of creditors and international capital markets Second, the empirical relationship between (see also Reinhart and Rogoff 2008b). bad output realizations and defaults is not as While the connection between capital tight as expected. Tomz and Wright (2007) market conditions and defaults has not been simulate a version of Aguiar and Gopinath’s emphasized very much in the classic literature (2006) model and show that the model pre- on sovereign debt, there is a ­parallel ­literature dicts that between 85 and 100 percent of on debt and currency crises in emerging mar- default episodes should happen during bad kets in which the effect of investor behavior times. In fact, only 62 percent of the default or expectations is the main focus. Unlike the episodes in their sample occurred when out- theoretical literature on sovereign debt sur- put was below trend. Tomz and Wright pro- veyed in section 3, this literature usually takes vide two interpretations for these findings. the existence (and sometimes the structure) First, in addition to output shocks, societies of sovereign debt as given. Conditioning on a may be subject to other shocks that affect the given level of debt, tighter international finan- trade-off between defaulting and repaying, cial conditions will make borrowing in bad particularly political shocks (one could inter- times more expensive, and defaulting a more pret these as shocks to national or governmen- attractive option. In the limit, external finan- tal preferences; see also Tomz 2007). Second, cial conditions could in fact make it impos- the definition of “bad times” could be broader sible to repay—for example, when there is a than just a situation in which output is below run on debt (Sachs 1984; Alesina, Alessandro trend. In particular, there could be exogenous Prati, and Tabellini 1990; Cole and Timothy swings in the credit constraint facing borrow- J. Kehoe 1996, 2000; and Marcos Chamon ing countries in addition to output shocks— 2007) or, with dollar-denominated debt, for example, driven by global credit cycles. If when there is a run on the currency (see defaults are more likely to occur during tight Philippe Aghion, Philippe Bacchetta, and global financial conditions, then this would Abhijit Banerjee 2001, 2004; Paul Krugman weaken the correlation between defaults and 1999; Craig Burnside, Martin Eichenbaum, domestic economic activity (and presumably and Sergio Rebelo 2004; and Olivier Jeanne also increase the incidence of defaults). and Zettelmeyer 2005b for a survey).25

24 Roughly speaking, the default clusters occurred a bad shock could be viewed as “willingness to pay” crises from 1820 until the mid 1830s, in the 1870s, in the 1890s, in the sense that, with sufficient adjustment (e.g., a large around World War I, in the 1930s, in the 1980s, and decline in consumption), repayment would be feasible. In between 1998 and 2003. contrast, Herschel I. Grossman and John B. Van Huyck’s 25 Liquidity or conditional solvency crises of this kind (1988) and Tomz’s (2007) distinction between “excusable” could, hence, be called true “ability to pay,” as opposed (or “expected”) defaults and pure repudiations (in essence, to “willingness to pay,” crises in which the country defaults in good times) is more useful. Most defaults are chooses not to repay. Beyond this, however, the distinc- arguably both in the “willingness to pay” category and tion between “willingness to pay” and “ability to pay” is of “excusable” in the sense that they are triggered by bad limited usefulness since even crises that are triggered by shocks or difficult debt market conditions. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 669

18

16

14

12

10

8

6

Number of sovereign default episodes 4

2

0 1820 1828 1836 1844 1852 1860 1868 1876 1884 1892 1900 1908 1916 1924 1932 1940 1948 1956 1964 1972 1980 1988 1996 2004 Year in which the country declared default

Figure 1. Default Clusters, 1820–2005

Source: Sturzenegger and Zettelmeyer (2007) and Borensztein and Panizza (2008).

A third perspective on debt crises, in addi- might be excessive because the parties that tion to output shocks and sudden reversals in contract the debt do not bear the full costs of international capital markets, focuses on the repayment or crises. For example, excessive idea that some countries may in fact “over- borrowing could benefit specific groups at borrow,” that is, accumulate debt that is too the expense of the average domestic taxpayer high from a welfare perspective, and at—or (Perotti 1996). Moral hazard could also occur perhaps just below—the debt level that at the expense of the foreign taxpayer, if ­competitive creditors will accept.26 Given this countries in crisis are “bailed out” by institu- high debt, small shocks (of whatever kind) tions such as IMF or World Bank, or through could trigger a default. Debt accumulation bilateral lending.27 Finally, ­overborrowing

27 For this argument to make sense, official loans must 26 Evidence for overborrowing is provided in contain a subsidy, either by carrying an interest rate that International Monetary Fund (2003), chapter 3, and does not reflect the riskiness of the loan for the official Mendoza and Jonathan D. Ostry (2002). Reinhart and lender or because the debtor country expects part of the Rogoff (2008a) examine domestic and external debt and loan to be forgiven. If this is not the case, the safety net defaults jointly and show that external defaults are often would be operated at no one’s expense and, hence, could driven by the accumulation of unsustainable domestic not be a source of moral hazard by definition (Jeanne and debt. Zettelmeyer 2001, 2005a). 670 Journal of Economic Literature, Vol. XLVII (September 2009)

(and overlending) may occur at the expense ­interpretations and, hence, only limited use- of preexisting creditors, if these have to share fulness as tests of theoretical predictions. One the recovery value of the debt with new cred- problem is that causality may often run both itors in the event of default (see Borensztein ways: it is exceedingly difficult to disentangle et al. 2005 for a discussion of this “debt dilu- causes and consequences of default, particu- tion” problem). larly since economic behavior could change In addition to the (small) literature on the in anticipation of crises. For example, the fact cyclical properties of defaults and debt crises, that short-term debt increases and reserve there is a much larger empirical literature on holdings decrease ahead of a default may indi- the determinants of debt crises that dates cate that liquidity shortages cause crises; but back to the work of William R. Cline (1984) it may also reflect the sovereign’s inability to and Daniel McFadden et al. (1985).28 The issue long-term debt when a default appears objective of this literature is mainly to predict imminent (Detragiache and Spilimbergo defaults (or say something about their likeli- 2001). Another problem is that a particular hood in a specific country situation) in a way fact, even when the direction of causality that is only loosely connected to theory. A dis- is clear, may be consistent with competing crete measure of debt distress—defined either theories. Assume the correlation between de jure, in line with the definition of default short-term debt and crises does in fact reflect used by rating ­agencies, or de facto, based on a causal relationship from the former to the the accumulation of arrears, nonconcessional latter. Even making this assumption, there are IMF lending, or secondary market sovereign competing interpretations. Higher short-term bond spread in excess of a critical threshold is debt makes more likely that countries will face typically regressed on a large number of “sol- a run; but it also increases the temptation to vency,” “liquidity,” and perhaps “willingness to default today rather than later. These are very pay” proxies, mostly with expected results. The different interpretations of why crises occur. probability of a debt crisis is positively associ- One way to use crisis regression models ated with higher levels of total debt and higher that is less sensitive to these problems is to shares of short-term debt, and negatively asso- use them to check whether the structure of ciated with GDP growth and the level of inter- the relationship between the probability of national reserves. Defaults are also related to default and its various economic and political more volatile and persistent output fluctua- correlates has remained stable or not. In par- tions, less trade openness, weaker institutions, ticular, we are interested in testing whether and a previous history of defaults. the changes in legal doctrine and practice While these papers are useful in establish- discussed in section 2 may have altered the ing the correlates of debt crises and creat- incentives to default. One way of doing this ing an inventory of “early warning signals,” is to interact the standard economic and their results sometimes have ambivalent political correlates with a dummy variable that takes the value of one for the post 1992 ­p e r i o d . 29 We conducted this experiment 28 This literature includes Enrica Detragiache and based on a logit model for all developing and Antonio Spilimbergo (2001); Catão and Bennett Sutton (2002); Paolo Manasse, Nouriel Roubini, and Axel Schimmelpfennig (2003); Reinhart, Rogoff, and Miguel A. Savastano (2003); Caroline Van Rijckeghem and Beatrice 29 We use this break point because of the 1992 deci- Weder (2004); Aart Kraay and Vikram Nehru (2006); sion of the U.S. Supreme Court (Republic of Argentina v. Mark Kruger and Miguel Messmacher (2004); Emanuel Weltover) that established that default on a contract that Kohlscheen (2005, 2006); and Andrea Pescatori and involves payments in the United States is sufficient to sat- Amadou N. R. Sy (2007). isfy the U.S. nexus requirement under FSIA. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 671 transition economies from 1970 until 2004 ­generally no structured negotiation process. using the set of explanatory variables studied Debt restructurings took the form of take-it- by Manasse, Roubini, and Schimmelpfennig or-leave-it exchange offers, though these were (2003) and the Standard & Poor’s definition usually preceded by informal discussions with of selective default. Only one of the inter- creditors. acted variables had a statistically significant The role of third parties—in particular, coefficient, and a Wald test revealed that the International Monetary Fund—in these the whole set of interacted variables was negotiations also changed. The IMF played not jointly significant (full results available an important role during the debt restructur- on request). Hence, institutional or legal ings of the 1980s, both as a source of inde- changes in sovereign debt after the 1980s do pendent information about the debt service not appear to have altered the relationship capacity of the debtor countries, and by pro- between economic and political variables viding new financing to the debtors (in addi- and the probability of a debt default. tion to the debt relief itself) conditional on economic adjustment and reform measures 4.3 How Are Defaults Resolved? (Erika Jorgensen and Sachs 1989; James M. The process through which debt crises are Boughton 2001; Rieffel 2003). In the 1990s, resolved—i.e., the debt is renegotiated—has the Fund still played its traditional role of changed significantly since the 1980s, mainly conditional lending to countries experienc- as a consequence of debt securitization and ing external financing crises, but generally changes in the identity and representation took a more distant approach to the debt of creditors.30 In the 1970s and 1980s, the cred- restructuring negotiations themselves. This itors of emerging market sovereigns tended to was motivated, in part, by the desire of not be banks. Debt took the form of syndicated appearing partial to either side31 and, in part, loans, and renegotiations were ­conducted by the fact that the Fund was itself a major through Bank Advisory Committees consisting creditor and hence faced a conflict of inter- of representatives of the major bank creditors ests in important restructuring cases such as (Lex Rieffel 2003). Each country negotiated Russia (1998–2000) or Argentina (2002–05). with just one Bank Advisory Committee. In The question is whether these institu- contrast, after the mid-1990s, creditors were tional changes had implications either for mainly bondholders with widely differing the efficiency of debt crisis resolution or the institutional characteristics—from pension costs of default for either debtors or credi- funds to individual “retail holders”—reflecting tors. In the late 1990s and the early years the return to emerging market bond finance of this decade, debt market participants after the Brady deals, in which defaulted bank and the policy community believed that it loans were exchanged for Brady bonds. There would, generally for the worse. It was feared, was no unified ­creditor representation and first, that the dispersion and heterogeneity

30 In this paper, we do not deal with the resolution of sector creditors as long as countries were conducting “good- defaults vis-à-vis official creditors because this is mostly faith” negotiations. This has not stopped the ­controversy, a political issue. For a discussion of the politics of official however. In particular, after Argentina’s default, credi- external debt, see Panizza (2008). tors criticized the Fund for lending to Argentina in spite 31 During the 1980s, the IMF was viewed as strength- of what they perceived as a lack of good faith negotiation ening the bargaining position of the banks because its pol- on the side of the Argentine government. For an indepen- icies initially did not allow it to lend to debtors in arrears. dent analysis of the IMF’s lending-into-arrears policy, see This policy was changed in the late 1980s and replaced by Javier-Díaz Cassou, Aitor Erce-Domínguez, and Juan J. a policy allowing the Fund to lend into arrears with private Vázquez-Zamora (2008). 672 Journal of Economic Literature, Vol. XLVII (September 2009) of bondholders would make it much more the high-profile bond restructurings since ­difficult for creditors to coordinate, making 1998 (see Sturzenegger and Zettelmeyer, for protracted and litigious debt restruc- 2007b for a description), only one—Argen- turing negotiations. Second, this would not tina (2001–05)—took more than two years. necessarily have benefits ex ante (as might Furthermore, in most of these recent cases be the case if protracted debt restructurings (Argentina is again the main exception) cred- make defaults more costly from a creditor itor participation was above 90 percent, and country perspective) both because long and both pre- and postrestructuring litigation has messy restructuring negotiations created a remained rare.34 deadweight loss that might be reflected in Cristoph Trebesch (2008) studies the deter- more costly borrowing, and because take- minants of delays in ninety restructuring epi- it-or-leave-it offers, combined with a more sodes between 1980 and 2007. He finds long fractured creditor side, would tend to shift delays (averaging approximately five years) in bargaining power toward the sovereign. the Brady era (1990–98) and much shorter These perceived problems motivated a large delays (between 1 and 1.5 years) in the pre- set of policy initiatives focused on mitigating Brady (1980–90) and post-Brady (1998–2007) collective action problems in sovereign debt eras. Trebesch also finds limited evidence of restructurings, ranging from issuing bonds prerestructuring litigations (litigation was an with collective action clauses that would obstacle to restructuring in only seven of the make changes in the payment terms agreed ninety cases included in his sample), and no by a supermajority of creditors legally bind- evidence that the number of creditors or the ing for all creditors to the creation of new type of instrument (bonds versus bank loans) institutions such as an international bank- is correlated with the duration of the restruc- ruptcy mechanism for sovereigns.32 turing process. His main conclusion is that Did these fears materialize? The answer, debtor characteristics—including measures by and large, appears to be no. of political risk, the debt profile, and other As far as the duration of default episodes economic characteristics—are a much more is concerned, Inter-American Development important predictor of the duration of debt Bank (2006) shows that the duration of the restructurings than creditor characteristics. average default episode declined from approx- Why did creditor coordination failures imately eight years in the 1970–90 period to turn out to be mostly a nonevent in the 1990s about four years since 1991.33 Compared to in spite of the lack of contractual or insti- the historical norm, recent defaults appear tutional coordination devices? 35 A possible to have been resolved in record time. Among answer is that the debtors ­themselves had

(sometimes­ credit rating agencies allow for a short grace 32 See Barry Eichengreen and Richard Portes (1995), period) and the moment in which debt restructuring is Group of Ten (1996), Krueger (2001), Sean Hagan completed. Postrestructuring litigations are not usually (2005), and Rogoff and Zettelmeyer (2002) for a sur- included in the computation of the length of the default vey. Theoretical analyses of these proposals include episode. Eichengreen, Kletzer, and Ashoka Mody (2003), Jeanne 34 Using a longer time series and different data, Reinhart (2004), Patrick Bolton and Jeanne (2007), Andrew G. and Rogoff (2008b) show that the median length of default Haldane et al. (2005), Pitchford and Wright (2007), and spells in the 1800–1945 period was twice as long than the Sergi Lanau (2008). median length of default spells in the 1946–2005 period. 33 Data presented in Benjamin and Wright (2008) leads 35 A few cases (e.g., Ukraine, 2000; Moldova, 2002) to the same conclusions. The duration of a default epi- were resolved with the help of collective action clauses sode is usually measured as the amount of time between but, for the most part, collective action clauses played the moment in which a country stops servicing its debt little or no role. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 673 some ­influence over potential ­coordination and the number of default episodes in the problems through the design of their exchange sample of Enderlein, Müller, and Trebesch offers, and by and large seem to have used (2008).37 The index is fairly stable (between this influence effectively (Bi, Chamon, and 2 and 2.9) during 1981–94, but becomes very Zettelmeyer 2008). For one thing, incen- volatile (oscillating between 1 and 5) in 1995– tives for costly litigation could be reduced 2007. In contrast, average coerciveness over by making an offer sufficiently attractive. five-year periods has remained more or less Furthermore, creditor coordination could be constant, ranging between 2.2 (in 1980–85) facilitated by setting “minimum participation and 2.8 (in 1991–95). Hence, figure 2 sug- thresholds” that made an exchange offer con- gests that changes in creditor composition tingent on high creditor participation, reas- or legal environment did not affect the coer- suring accepting creditors that they could civeness on average, but may have affected revert to their original claim if the exchange its volatility (perhaps by encouraging either turned out to be a failure. Minimum par- a cooperative attitude that avoided litigation ticipation thresholds were in fact used in all altogether, or all-out conflict). This said, it is major debt exchanges except for Argentina’s possible that the increase in volatility is sim- 2005 exchange. In addition, “exit consents,” ply driven by the smaller number of defaults in which creditors accepting the exchange in the recent period (on average 2.8 per offer were asked to consent to changes in the year in 1995–2007, versus 15.2 per year in nonpayment terms of the original bonds, were 1981–94). Indeed, the index takes its extreme used to discourage holdouts in some restruc- values in 2001, 2006, and 2007, all years in turings (Ecuador, 2000; Uruguay, 2003; which there is only one default episode. Dominican Republic, 2005; see Sturzenegger Consistent with the behavior of Enderlein, and Zettelmeyer 2007b for details).36 Müller, and Trebesch’s procedural index, There is also no evidence that recent bond actual creditor losses in the 1998–2005 restructurings have resulted in more “coer- period show a high degree of variation, from cive” creditor treatment or that the prac- very high losses in Argentina’s 2005 restruc- tice of take-it-or-leave-it offers has shifted turing—about 75 percent—to low losses in ­bargaining power to debtor countries. Henrik Uruguay’s (2003) external restructuring in Enderlein, Laura Müller, and Trebesch (2008) the order of 13 percent (Sturzenegger and build an index of coerciveness for thirty- Zettelmeyer 2007a, 2008). Furthermore, eight emerging market default episodes in there is a strong, albeit not perfect, correlation the 1980–2006 period. The index is based between investors’ losses and the procedural on procedural criteria that aim to measure index (figure 3). Finally, estimates of debt whether a defaulting government strived to forgiveness based on face value reductions solve the crisis in cooperation with its exter- and interest forgiven compiled by Benjamin nal creditors, or decided to take an aggressive and Wright (2008) for ninety default epi- stance. Figure 2 plots the coerciveness index sodes that were initiated between 1979 and

36 A second reason why incentives to hold out may debt markets in the 1990s implied that defaulted debt was have been less pronounced than was originally feared is marked to market value. By the time of a debt exchange related to the tradability of debt and to the introduction offer, losses had, hence, already been realized and credi- of mark-to-market accounting (we thank Charlie Blitzer tors were typically keen to capture the upside associated for this observation). In the 1980s, lack of tradability with the new instruments on offer. allowed banks to value sovereign loans at face value while 37 Each bar measures the number of the countries that they were being rolled over. Accepting a debt exchange are in default in a given year and not the number of coun- amounted to recognizing a loss. In contrast, secondary tries that entered default in that year. 674 Journal of Economic Literature, Vol. XLVII (September 2009)

6 20 Number of defaults (right scale) Coerciveness index (yearly values) 18 Coerciveness index (5-year weighted average) 5 16

14 4 12

3 10

8 Number of defaults Coerciveness index 2 6

4 1 2

0 0 1980 198 1 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year

Figure 2. The Index of Coerciveness

Source: Own calculations based on data from Enderlein, Müller, and Trebesch (2008).

2005 suggest that the defaults that began 4.4 What Is the Cost of Default for before 1995 involved debt write downs that Debtors? were more than twice as big than those of defaults that began after 1995 (the ­“haircuts,” For a sovereign debt market to exist, in Benjamin and Wright’s definition, are defaults must be costly in at least some states about 22 percent for the more recent group of the world. As we have seen, models of sov- of defaults and about 45 percent for the pre- ereign debt distinguish themselves primarily 1995 group of defaults; restricting the latter in terms of which cost they emphasize. We group to the Brady deal countries leads to now briefly review what the empirical litera- about the same average haircut). While these ture has to say on this subject and whether it estimates are crude because they do not take lends support to specific theories (or classes into account net present value losses due to of theories).38 maturity extension, they are consistent with the idea that investors did not receive harsher treatment in the post-1995 bond restructur- 38 See also the surveys by Bianca De Paoli, Glenn Hoggarth, and Victoria Saporta (2006); Hatchondo, ings compared to the bank debt restructur- Martinez, and Sapriza (2007a); and Borensztein and ings of the 1980s and early 1990s. Panizza (forthcoming-a). Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 675

40 _ ·ARG

20 _ ·RUS

0 _

PAK UKR ECU Haircut (deviation from the sample mean) · · ·

20 _ − URY _ · _ _ _ 4 2 0 2 4 − − Index of coerciveness (deviation from the sample mean)

Figure 3. Haircut and the Index of Coerciveness

Source: Haircut data are from Sturzenegger and Zettelmeyer (2007) and coerciveness data are from Enderlein, Müller, and Trebesch (2008).

4.4.1 Capital Market Exclusion have regained access to international capital markets fairly quickly. There is clearly some capital market exclu- Defining “access” as bond issuance or sion period following a default. This typically bank borrowing in international markets, encompasses the default period, i.e., the Sandleris, Gaston Gelos, and Ratna Sahay period until the conclusion of a debt restruc- (2004) show that, in the 1980s, countries turing. Once this has concluded, however, were excluded from international capital countries defaulting in the last three decades markets for about four years on ­average after their defaults ­ended.39 After the 1980s,

creditors. In this sense, capital market exclusion was not 39 Arguably, one needs to add to this the average rene- complete even during the renegotiation period. The same gotiation period while countries are in default, which was is true for the more recent renegotiation periods, dur- long in the 1980s (about eight years, see Benjamin and ing which debtors typically both had access to official Wright 2008). This said, most countries that defaulted credit, and sometimes were able to issue new domestic in the 1980s received several debt reschedulings as well debt—including to international creditors—before a debt as “new money” lending from both private and official restructuring agreement had been concluded. 676 Journal of Economic Literature, Vol. XLVII (September 2009) reaccess following exit from default was even the most important factors determining the faster (0–2 years).40 Using a stronger defini- speed with which countries return to posi- tion of “access”—positive net transfers— tive net borrowing. Christine Richmond and Daniel A. Dias In light of this evidence, how satisfactory (2008) find somewhat longer exclusion peri- are sovereign debt models based on capital ods of 5.5 years in the 1980s, 4.1 in the 1990s, market exclusion? The fact that real-world and 2.5 in this decade. Levy-Yeyati (forth- capital market exclusion is temporary is not coming) finds that countries that defaulted per se a problem for modern theories: begin- in the 1970–2004 period receive lower net ning with Cole, James Dow, and William B. transfers in the years that follow the default English (1995) and Kletzer and Wright (2000), episode. However, the effects are fairly small: sovereign debt models based on reputation in the impact of past defaults on net transfers capital markets have typically dispensed with ranges between 0.1 and 1 percentage points the assumption of permanent capital market of GDP. Arráiz (2006a) presents evidence exclusion. Furthermore, some of these recent showing that countries that defaulted in the models—including Natalia Kovrijnykh and past are excluded from the capital market Balazs Szentes (2007), Benjamin and Wright for a shorter period than first time default- (2008), and Bi (2008a)— can generate rene- ers. She interprets this as an indication of the gotiation patterns and capital market exclu- fact that countries with a history of defaults sion periods that seem roughly in line with have revealed to the credit market how what is observed in reality. they might manage possible future defaults. At the same time, however, it is clear from Global credit cycles seem much more the evidence and the calibrated models that important than default history in determin- fear of exclusion from capital markets cannot ing market access. For instance, in the period be the only—or even the main—reason why between the end of the World War II and the countries repay their debts. Arellano and mid 1960s almost no developing country had Jonathan Heathcote (2008) show that a world access to the international capital market. in which the only cost of default is perma- This included both countries that defaulted in nent exclusion from future borrowing would the 1930s, and countries (such as Argentina, yield maximum sustainable debt levels which for example) which had made great efforts are at least one order of magnitude smaller to avoid default and maintain a good repu- than the debt levels that we observe in the tation.41 Conversely, almost all countries that real world. Presumably, temporary exclusion, defaulted in the 1980s regained international as observed after actual defaults, would yield capital market access in the 1990s. Richmond even lower sustainable debt levels. Indeed, it and Dias (2008) confirm that external finan- has become standard practice in calibrated cial market conditions—proxied by the models of sovereign debt to assume an addi- spread on high-yield corporate bonds in the tional exogenous output cost of default in United States and U.S. T-Bill rates—are order to generate realistic debt levels.42

41 Argentina may have been rewarded by accessing 40 This may overstate the speed of access because capital markets just before World War II, however, while Sandleris, Gelos, and Sahay exclude countries that did not countries that defaulted in the 1930s were excluded (Tomz regain access to international markets at all during their 2007). (1980–2004) sample period. However, this latter group 42 For example, Laura Alfaro and Fabio Kanczuk consists of only a few countries (Bolivia and a small set of (2005), Arellano (2008), Aguiar and Gopinath (2006), Bi African countries that defaulted in the 1980s). (2008a), and Benjamin and Wright (2008). Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 677

4.4.2 Cost of Borrowing ­countries that defaulted either in the 1930s or in the postwar period were charged slightly The evidence on the effect of defaults on higher spreads in the 1968–81 period (in the the cost of borrowing has a similar flavor as order of 25 and 40 basis points, respectively); that on market exclusion. Immediately fol- and Giovanni Dell’Ariccia, Isabel Schnabel, lowing a default episode—that is, after a and Zettelmeyer (2006) have a similar result debt restructuring has been concluded— for the 1990s with respect to countries that borrowing costs tend to be much higher defaulted in the 1980s. This said, the precision than in tranquil times, controlling for fun- and, hence, statistical significance of Özler’s damentals (Sturzenegger and Zettelmeyer (1993) results may be overstated because the 2007a; Borensztein and Panizza forthcom- regression is based on loan-level data with- ing-a). However, this effect is short-lived. out clustering of standard errors. Indeed, Based on a sample of thirty-one emerging in a paper examining borrowing costs dur- market countries in the 1997–2004 period, ing the same period using country-level data Borensztein and Panizza (forthcoming-a) and a different methodology, Péter Benczúr find that, in the year after a default episode, and Cosmin Ilut (2006) do not find a statisti- spreads are about 400 basis point higher cally significant effect of distant (pre-1970s) than in tranquil periods, but this premium default history on spreads, although they do falls to 250 basis points in the second year find an effect of recent default history. and loses statistical significance and quickly Overall, these findings do not lend much declines further in the following years. support to theories of sovereign debt based Marc Flandreau and Frédéric Zumer (2004) on maintaining a good reputation in credit find a similar pattern for the 1880–1914 markets. Except in the short run, the effects period: default episodes are associated with of defaults on borrowing costs seem small, an increase in spreads of approximately 90 and eventually disappear. Defaults do not basis points in the year that follows the epi- seem to affect borrowing costs in a way sode, but the effect of the default dies out which is both long-lived and quantitatively very rapidly. important.43 Hence, by itself, the effect of These findings are consistent with several default on borrowing costs does not seem to papers that study the effects of defaults on be a plausible deterrent of default. This con- borrowing costs over longer periods. Peter clusion is supported by a recent calibrated H. Lindert and Peter J. Morton (1989), model due to Alfaro and Kanczuk (2005), Bhagwan Chowdhry (1991), and Sule Özler which shows that interest rate penalties can- (1993) all show that defaults in the nineteenth not sustain equilibria with positive sovereign century and in the early twentieth century debt unless it is assumed that the short-lived had no effect on borrowing costs in the rise of interest rates after a default induces 1970s. However, Özler (1993) does find that large output costs.

43 Other empirical work aimed at testing the reputa- ratings­ published by Institutional Investor. However, tion in credit markets focused on the behavior of credit Catão and Kapur (2006) find that this result is not robust ratings. Richard Cantor and Frank Packer (1996) show to including additional economic variables in the regres- that a dummy variable that takes value one for countries sion. Borensztein and Panizza (forthcoming-a) show that that defaulted in the 1970–95 period is associated with defaults initially have a large negative impact on credit a two-notch drop in the country’s credit rating in 1995. ratings; however, the correlation between default and Reinhart, Rogoff, and Savastano (2003) show that default credit rating tends to disappear about five years after the history is significantly and negatively correlated with default episode. 678 Journal of Economic Literature, Vol. XLVII (September 2009)

4.4.3 Sanctions the “real” cause of a military intervention or not, as long as defaults increase the chances As we have seen in section 3, economic of such an intervention. models of sovereign debt have sometimes Regardless of how the debate between assumed that creditors can impose direct Tomz (2007) and Mitchener and Weidenmier penalties on the defaulting country, in addi- (2005) is resolved, there does not appear to tion to (or instead of) punishing defaulters be any recent evidence for supersanctions through future capital market exclusion or (in particular, following the debt defaults of higher borrowing costs. The question is what the 1980s and 1990s). One possibility is that form such sanctions might take and whether supersanctions lost their significance as sov- there is any evidence for them. We briefly ereign immunities were reduced after World review three types of sanctions: political or War II and the potential role for private military pressure by Western governments enforcement through the courts increased. acting in the interests of creditors, legal sanc- Indeed, as documented in section 2, in the tions (including actual or threatened asset 1990s some holdout creditors received (near) seizures by private creditors), and reductions full repayment, sometimes backed by the in trade. threat of disrupting financial transactions of Kris James Mitchener and Marc D. the debtor abroad, which in turn was based Weidenmier (2005) document about a dozen on court judgments allowing the creditors cases of “supersanctions” during the classical to seize commercial assets of the debtor gold standard period of 1870–1914. These (diplomatic assets remain protected by sov- took the form actual or threatened military ereign immunity). However, in all cases in intervention (“gunboat diplomacy”), typically which holdouts were successful, they owned leading to direct control of customs or tax only a small portion of the total outstanding revenues on behalf of creditors (for exam- debt. The penalty involved with repaying ple, in Tunisia, 1870; Egypt, 1882; Turkey, these holdouts would, hence, have been far 1882; Greece, 1898; Morocco, 1905; and, in too small to deter a default. Furthermore, the early twentieth century, several Central the potential for holdouts to deter defaults American countries). In some cases, such as remains limited by the availability of debtor Tunisia, Egypt, and Morocco, these inter- country assets abroad, and the ingenuity of ventions were followed by a loss of political debtors in structuring international financial independence, i.e., with debtor countries transactions so as to avoid large asset hold- becoming “protectorates.” 44 Whether or not ings in jurisdictions where holdouts have these episodes should be viewed as punish- obtained court judgments. ment for default, however, is controversial. Finally, much attention has focused on Tomz (2007) argues that gunboat diplomacy declines in international trade as a potential was driven by the coincidence of defaults with cost of default. For instance, an influential other disputes (civil wars, territorial conflicts, paper by Carlos F. Díaz-Alejandro (1983) and tort claims) that he suggests were the argues that Argentina did not default in the real cause of the military intervention. This 1930s in order to protect its trade ­relations said, from the perspective of default incen- with Great Britain. Andrew K. Rose (2005) tives it might not matter whether defaults are uses bilateral trade data to study the effect of Paris Club debt rescheduling and finds that debt renegotiations are associated 44 In addition, there were several cases of “softer” political or diplomatic intervention on behalf of creditors with a decline in bilateral trade of approxi- (Paolo Mauro, Nathan Sussman, and Yishay Yafeh 2006). mately 8 percent per year, and that defaults Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 679 affect trade for a long period (fifteen years). (forthcoming-a) test this hypothesis, with Borensztein and Panizza (forthcoming-b) use mixed results: while default episodes are industry-level data and show that sovereign associated with a decline in trade credit, the defaults are costly for export oriented indus- relationship between trade and default is tries. In contrast to Rose’s finding, these not affected by including trade credit in the effects appear to be fairly short-lived (three to regression. Carlos Arteta and Galina Hale four years). Lanau (2008) also uses industry- (2008) use firm-level data and show that level data and finds that import-competing sovereign defaults are negatively associated firms benefit from defaults in relative terms, with domestic private firms’ access to foreign consistent with the idea that defaults reduce credit. However, they find that this effect is trade and, hence, competition from abroad. stronger for nonexporters that for exporting There is also indirect support for the thesis firms. Thus, the channel linking default to that defaults lead to trade reductions. If the trade remains a mystery. cost of default goes through bilateral trade, it 4.4.4 Domestic Costs is plausible that higher levels of international trade should be associated with higher lev- As we saw in section 4.2, defaults tend to els of bilateral lending. Rose and Mark M. be negatively correlated with domestic out- Spiegel (2004) test and find support for this put: they tend to happen in bad times. So far, hypothesis. Along similar lines, Lane (2004) we have interpreted this correlation in line shows that countries that trade more can sus- with the causality offered by insurance mod- tain higher levels of external debt. els of sovereign debt, that is, with the causal- While the notion that defaults reduce ity running from output to defaults. However, trade, at least temporarily, is well established, there could also be a causal link in the other its role in deterring defaults remains contro- direction. Defaults could cause output drops, versial. Tomz (2007) takes issue with Díaz- or make already bad output states worse, at Alejandro’s argument regarding the motives least in the short run. If so, this might consti- for Argentina’s determination to avoid default tute an extra reason for why countries gener- in the 1930s. English (1996) studies defaults ally try to repay their debts. by U.S. states in the nineteenth century and A recent literature based on cross-coun- points to the fact that since foreign lenders try regressions has attempted to shed some could not impose trade sanctions on individual light on this subject. Based on cross-section states that defaulted on their debt, the states and panel growth regressions, Sturzenegger that paid back must have done so for repu- (2004) finds that default episodes are tational reasons and not because they were associated with a reduction in growth of afraid of a trade embargo. Furthermore, the approximately 0.6 percentage points. If the channel through which defaults affect trade default comes with a banking crisis, growth remains something of a puzzle. Any evidence decreases by 2.2 percentage points. De Paoli, linking trade declines to “supersanctions” is Hoggarth, and Saporta (2006) also find that limited to the Gold Standard era (Mitchener output losses (i.e., periods in which actual and Weidenmier 2005). GDP is below trend GDP) are correlated A possible interpretation for the more with default episodes and increase with the recent periods could be that, in the after- duration of the default episode. In contrast, math of a default episode, both importers using quarterly data, Levy-Yeyati and Panizza and exporters lose access to credit and the (2006) find that defaults tend to happen in decline in trade is driven by the presence of the trough of a contraction and often mark credit constraints. Borensztein and Panizza the beginning of the recovery. 680 Journal of Economic Literature, Vol. XLVII (September 2009)

How can these results be reconciled? had a statistically significant and, at 1 per- Growth regressions involving default dum- cent, quite sizable effect. We also find that mies could suffer from not one but at least the impact of predicted defaults is not sig- two biases. First, and most obviously, defaults nificantly different from that of unpredicted could be endogenous to output declines, defaults. as theory does indeed predict, imparting While these regressions do not fully deal a downward bias on the default dummy’s with the endogeneity problem—including regression coefficient. Second, it is pos- because they rely on a particular empirical sible that output declines not in reaction to model for identifying the default surprise, defaults, but in reaction to default expecta- which may or may not be correct—they tions. A regression focusing on the contem- do provide some backing for the idea that poraneous and lagged effects of defaults at defaults, both expected and surprises, may higher frequencies (annual perhaps, and cer- cause output losses. This is also backed by tainly quarterly) could miss this effect. case studies (International Monetary Fund Recent papers by Gisella Chiang and 2002; Sturzenegger and Zettelmeyer 2007b) Javier Coronado (2005) and Borensztein and that suggest specific causal channels through Panizza (forthcoming-a) attempt to address which default may make economic crises these biases using a two-stage approach. First, worse—in particular, by causing a run on the probability of defaults is estimated using banks, and by exacerbating capital flight45— a probit model involving various predictors and by recent papers that investigate spe- of debt crises, and then the predicted default cific channels. Borensztein and Panizza probabilities are used in a second regression (forthcoming-a) find that sovereign defaults to explain output. In Chiang and Coronado are associated with an increase of the prob- (2005), the second stage regression involves ability of a banking crises. Miguel Fuentes a default dummy and the predicted default and Diego Saravia (2006) show that defaults probability as an addition control (defined for lead to a fall in FDI flows into the country, all time periods). Borensztein and Panizza with this reduction concentrated in flows (forthcoming-a) run a second stage regression ­originating in creditor countries.46 Arteta in which the default dummy is decomposed and Hale (2008) show that foreign credit to into predicted and unpredicted portions. the private sector collapses in the aftermath Both are statistically significant, although of a default, though it is not clear whether the effect of the unpredicted portion is a bit this is driven by a reduction in the supply smaller, and both effects appear to be short- of credit or a reduction in the demand for lived. credit. Table 3 gives the flavor of these results What are the implications of these findings and also checks whether recent default for sovereign debt theory? Most obviously, episodes had a different effect on growth by interacting the default dummy with a 45 A useful comparison in this regard is between the dummy variable that takes value one for the crises in Argentina in 2002 (currency crisis and default) 1990s. Column 2 shows that recent defaults and Brazil in 1999 (currency crisis but no default). The had a smaller impact on growth but the capital account reversal was much worse in Argentina. In Brazil, debt flows collapsed but FDI held steady and coefficient remains negative and statistically even increased. In Argentina, both debt flows and FDI significant at the 5 percent confidence level. collapsed in spite of the fact FDI was not directly affected Column 3 undertakes the decomposition by the default. 46 Intriguingly, they also find no effect on debtor coun- into expected defaults and default surprises tries flows to creditor countries, suggesting that sanc- and shows that even unpredicted defaults tions—if any—are ineffective. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 681

Table 3 Defaults and GDP Growth

(1) (2) (3)

DEFAULT 1.309*** 1.649*** −(0.29) −(0.40) DEFAULT*D90 0.703 (0.51) UNPRED_DEF 0.937** − (0.38) PRED_DEF 1.437** − (0.64) Observations 2,048 2,048 843 R2 0.22 0.22 0.26

Tests: p-value p-value DEFAULT*D90 DEFAULT 0 0.011** + = UNPRED_DEF-PRED_DEF 0 0.491 = Notes: All regressions are based on pooled data for the 1970–2006 period. The dependent variable is the growth rate of GDP per capita. The control variables are year fixed effects, regional fixed effects, invest- ment ratio, population growth, initial income, education, government consumption, index of civil rights, terms of trade shocks, and trade openness. DEFAULT is a dummy variable that takes a value of one when a country is in default; DEFAULT*D90 is a dummy variable that takes a value of one in the years 1990–2006; UNPRED_DEF is a variable that measures the unexpected component of default (obtained from the first- stage probit); PRED_DEF is a variable that measures the expected component of default. Robust standard errors in parentheses. ** p 0.05 < *** p 0.01 <

evidence that the cost of defaults are mainly markets were inoperative (for example, in domestic costs gives a boost to new theories the postwar period, prior to the late 1980s) of sovereign debt, such as Broner, Martin, and that some defaults appear to have suc- and Ventura (2006), Sandleris (2005), or cessfully discriminated between foreign and Mendoza and Yue (2008), which do not rely domestic debtholders (see Sturzenegger and on external sanctions or capital market exclu- Zettelmeyer 2007b for some recent cases). sion (see section 2). This said, these alterna- While domestic default costs are clearly tive approaches may of course face empirical outside the scope of models á la Eaton and challenges of their own. For example, Broner, Gersovitz—that is, models emphasizing Martin, and Ventura’s elegant theory based reputation in credit markets—they may be on secondary markets and the government’s consistent with broader reputation-based inability to target defaults to foreigners theories in which defaults reveal information must contend with the fact that sovereign about the institutions, preferences, or deep debt existed even at a time when secondary structural characteristics of the borrowing 682 Journal of Economic Literature, Vol. XLVII (September 2009) country, which then trigger a range of eco- may have a similar effect.48 If confirmed by nomic consequences (Cole and Kehoe 1998; further research, this finding would open the Sandleris 2005; Catão and Kapur 2006; possibility that defaults occur too rarely (or Kapur, Fostel, and Catão 2007). Indeed, the not soon enough) from a social perspective, at panic and pessimism that is characteristic for least in an ex post sense, as politicians “gam- economies suffering large defaults has the ble for redemption.” This argument has been flavor of “reputational spillovers” in which made, for example, with regard to Argentina’s confidence in the government is undermined 2001 default, though it is difficult to prove with respect to issues beyond just external (see Sturzenegger and Zettelmeyer 2007b). debt. What other assets might be confis- Furthermore, since political default costs cated? Will the rights of investors holding would help make sovereign debt affordable, equity or owning businesses be curtailed? it is not obvious that they would lead to an The consequence of such a generalized lack inefficiency ex ante. To our knowledge, a sys- of faith could be a large reversal of inflows, tematic analysis of the relationship between capital flight, or even a run on deposits—as sovereign debt, defaults, and political career observed in many debt crises.47 concerns has not been undertaken and is an Finally, an intriguing possibility related interesting area for future research. to domestic costs of default focuses on 4.4.5 Evidence from the Most Recent political economy issues in debtor countries. Defaults Economic theory usually treats debtors like “representative agents,” but this is not neces- The evidence discussed so far is based sarily a good assumption. Hence, a potential mostly on defaults and renegotiations that reason for why countries repay their debts is took place by the early 1990s. We now ask what that defaults inflict costs on the politicians or the most recent (1998–2005) ­restructuring government officials that make the decision episodes teach us about the costs of default, to default, who may lose their jobs, or ­damage and whether they appear to be in line with their political careers. There is tentative evi- the picture that we have sketched so far. dence for this. Richard N. Cooper (1971) and Table 4 lists eight well-known recent epi- Jeffrey A. Frankel (2005) show that currency sodes and classifies them in terms of size of devaluations are often followed by electoral the restructuring; the size of the “haircut” losses of the ruling party and reduce the (investor loss) involved in each restructur- tenure of the chief of the executive and the ing; and whether restructurings were initi- minister of finance; Borensztein and Panizza ated before or after the country had missed (forthcoming-a) show that default episodes payments. Although this sample is small, it turns out to be very diverse. With respect to the first criterion, the sample includes the largest default ever recorded (Argentina in 2001) and a few very small defaults (Moldova 47 A challenge to the “reputational spillovers view” is the fact, documented by Tomz and Wright (2008), that and Pakistan). With respect to the second debt defaults and expropriations of foreign direct invest- criterion, the sample includes a few defaults ment are not synchronized, with most postwar expropria- with very large haircuts (above 50 percent tions concentrated in the 1970s, ahead of the modern era of debt crises. However, this fact could still be consistent in the cases of Argentina and Russia) and a with the presence of limited reputational spillovers, which a defaulting country might attempt to contain, for exam- ple, by reaffirming the rights of foreign direct investors 48 These are simple correlations that do not control for (on expropriation and direct investment, see also Cole and the fact that defaults often come at time of economic crisis English 1991). and, thus, should be interpreted with caution. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 683

Table 4 Characteristics of Recent Debt Restructurings

Total amount restructured1 Haircut Country Year (bill US$) (%) Type of restructuring

Russia 1998–2000 38.7 52.6 Postdefault

Ukraine 1998–2000 7.8 28.9 Predefault

Pakistan 1999 0.61 31 Predefault

Ecuador 1999–2000 6.5 28.6 Postdefault

Argentina 2001–2005 145 75 Pre- and postdefault

Uruguay 2003 5.4 13.3 Predefault

Moldova 2002 0.08 37 Pre- and postdefault

Dominican Republic 2005 1.5 2 Predefault

1 Domestic and external debt with private creditors. Source: Sturzenegger and Zettelmeyer (2007, 2008).

restructuring with basically no haircut (the capita of at least US$500 and controls for Dominican Republic). Finally, about half both country and year fixed effects, sug- of the restructurings listed in table 4 were gests not. In the year of the default episode, preemptive (i.e., they took place before the private capital flows to the defaulting coun- country missed any payment on its existing tries were slightly below trend but started debt) while the other half were postdefault to recover immediately thereafter and, restructurings.49 within three years of the episode, they were Consider first whether there is any evi- already above trend. Argentina, Russia, and dence of capital market exclusion. Figure Ecuador observed a collapse of capital flows 4, based on a regression that includes all one or two years before the default. In these developing countries with an income per countries, capital inflows reached a trough in the year after the default but then recov- ered quickly. The case of Argentina is par- 49 For detail on these restructurings, see Sturzenegger ticularly interesting. This country had by far and Zettelmeyer (2007b, 2008). Harald Finger and the largest and least creditor friendly default Mauro Mecagni (2007) examine the question of whether the restructurings were successful in restoring debt in this group. Nonetheless, two years after sustainability. the default, private inflows were so high that 684 Journal of Economic Literature, Vol. XLVII (September 2009)

All countries Argentina Dominican Republic

.1 .05 .02 0 0 0 .02 − .1 .05 .04 − − − .06 .2 .1 − − − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Ecuador Moldova Pakistan

.1 .2 .02 .15 0 .05 .1 .02 .05 −.04 0 0 −.06 − .05 .05 .08 − − − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Russia Ukraine Uruguay .1 .05 .05 0 0 0 .1 − .05 .05 .2 − − − .1 .1 .3 − − − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Figure 4. Recent Defaults and Private Capital Flows

Notes: The figure plots the residuals of a regression that controls for country and year fixed effects and that includes all developing countries that had an income per capita greater than US$500 in the year 2000.

the country had to impose capital controls costs, based again on a large panel regres- on inflows. Profit ­opportunities—perhaps sion that controls for country and time fixed linked to the behavior of the real exchange effects, and excludes the months in which rate—seemed to have dominated any rep- a country is in default. The main result is utational ­considerations. This is not to say that—controlling for changes in global that the restructuring strategy may not have financial conditions (via time dummies)— had an impact on the behavior of capital postdefault spreads return to predefault flows around the time of the restructuring. levels within twenty-four months or less. Countries that opted for a preemptive strat- However, figure 4 does not control for egy (Dominican Republic and Uruguay) changes in the fundamentals of defaulting seemed to enjoy a recovery of private inflows countries. If these improve as a result of even before the restructuring. However, the the restructuring, the rapid convergence evidence suggests that effects on the volume shown in the figure could still be consistent of capital flows were at best transitory. with the idea that defaulters pay higher Figure 5 examines whether there is any spreads than nondefaulters with similar ­evidence for “punishment” via borrowing fundamentals. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 685

All countries Argentina Dominican Republic 3000 3000 2000 bps bps 0 0 1000 − 36 24 12 0 12 24 36 36 24 12 0 12 24 36 36 24 12 0 12 24 36 − − − − − − − − − Event time, months Event time, months Event time, months

Ecuador Pakistan Russia 2000 2000 5000 bps bps bps 0 0 0

36 24 12 0 12 24 36 36 24 12 0 12 24 36 36 24 12 0 12 24 36 − − − − − − − − − Event time, months Event time, months Event time, months

Ukraine Uruguay 2000 2000 bps bps 0 0

36 24 12 0 12 24 36 36 24 12 0 12 24 36 − − − − − − Event time, months Event time, months

Figure 5. Spreads Before and After Defaults

Notes: The figure plots the residuals of a regression that controls for country and year fixed effects and that includes all countries that are included in the JP Morgan EMBI+ Global.

To deal with this objection, we regress one in each year after the third year of the average spreads in year t on economic fun- default episode (D t 3).51 Column 1 of > + damentals measured in year t 1, in addi- table 5 reports the results of the model esti- − tion to year fixed effects, in a 1994–2008 mated controlling for both credit ratings and sample (that is, centered on the recent economic fundamentals. We find a positive default episodes).50 Our variables of ­interest but statistically insignificant effect of default are three dummies that take value 1 in each on spreads in the first two years, while the of the three years after the resolution of coefficients on (Dt 3) and (D t 3) are + > + the default episode (DEFt 1, DEFt 2, and statistically significant and negative. When + + DEFt 3) and a dummy that takes value we repeat the regression without ­controlling +

51 Thus, if a country defaulted in 1998 and concluded 50 We measure fundamentals with the log of GDP per the episode in 2000, Dt 1 takes value one in the year + capita (GDP_PC), the current account balance divided by 2001, Dt 2 takes value one in 2002, Dt 3 takes value one GDP (CA/GDP), log inflation (INF), total public debt over in 2004,+ and D t 3 takes value one+ in 2005, 2006, > + GDP (TPuD/GDP), and the share of public external debt 2007, and 2008. In countries that never defaulted, the over total public debt (EPuD/TPuD). four dummies always take value zero. 686 Journal of Economic Literature, Vol. XLVII (September 2009)

Table 5 Default History and Sovereign Spreads, (Random Effects Estimations)

Dependent variable

EMBI spread EMBI spread Credit rating

DEFt 1 108.7 307.2*** 1.015* + − (95.04) (103.4) (0.608)

DEFt 2 109.6 261.7*** 1.666*** + − (82.45) (92.75) (0.553)

DEFt 3 142.1** 62.64 1.098** + − − − (65.40) (78.65) (0.477) DEF t 3 145.2*** 197.3*** 0.447 > + − − − (51.75) (75.95) (0.502)

Ln(GDP_PC)t 1 32.98 7.590 2.084*** − − (23.04) (52.74) (0.427)

(CA/GDP)t 1 299.6 275.6 7.415*** − − − (190.2) (271.3) (1.654)

Ln(INF)t 1 0.745 15.54 0.103 − − − (10.48) (12.00) (0.0685)

(TPuD/GDP)t 1 48.02 120.7*** 3.124*** − − − (34.54) (42.53) (0.675)

(EPuD/TPuD)t 1 146.8** 273.5*** 1.078*** − − (57.55) (100.2) (0.253) Constant 1438*** 742.0 5.975 − (285.6) (464.5) (3.686)

Observations 336 336 329 Number of countries 32 32 32

Controls Year fixed effects Year fixed effects Year fixed effects Credit rating fixed effects Period 1994–2008 1994–2004 1994–2008

Notes: In columns 1 and 3, the dependent variables measure average EMBI sovereign spreads. In column 3, the dependent variable is based on a numerical coding of S&P long-term foreign currency sovereign ratings (2 corresponds to CC and 21 corresponds to AAA). DEFt 1 is a dummy variable that takes value 1 in the year + after the resolution of the default episode, DEFt 2 is a dummy variable that takes value 1 two years after the + resolution of the default episode, DEFt 3 is a dummy variable that takes value 1 three years after the resolu- tion of the default episode, DEF t +3 is a dummy variable that takes value 1 from the fourth year after the resolution of the default episode. >Ln(GDP_PC)+ is the log of GDP per capita, CA/GDP is the current account balance divided by GDP, Ln(INF) is log inflation, TPuD/GDP is total public debt over GDP, and EPuD/ TPuD is the share of public external debt over total public debt. All regressions control for global factors with year fixed effects. Robust standard errors in parentheses. * p 0.1 ** p < 0.05 < *** p 0.01 < Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 687

All countries Argentina Dominican Republic .15 .1 .1 .1 .05 0 0 .05 .1 .05 0 − − .1 .05 .2 − − − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Ecuador Moldova Pakistan .1 .1 .04 .05 0 .02 0 .1 0 − .02 − .05 .2 .04 − − − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Russia Ukraine Uruguay .1 .15 .1 .05 .1 .05 .05 0 0 0 .05 .05 .05 − − − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Figure 6. Recent Defaults and Exports

Notes: The figure plots the residuals of a regression that controls for country and year fixed effects and that includes all developing countries that had an income per capita greater than US$500 in the year 2000.

for credit ratings, the default dummies Turning to direct costs of defaults, figure become statistically significant and posi- 6 shows the behavior of exports around the tive, but only in the first two years after the default dates. Again, we do not find any hard ­resolution of the default episode (column evidence that defaults have a long-lasting 2). The interpretation for these conflicting negative effect. For the average country, results must be that defaults lead to lower in the year of the default trade was slightly credit ratings, so that controlling for credit below trend and picked up in the year after ratings there is no positive impact on bor- the default. However, there is a lot of hetero- rowing costs. This is confirmed by column geneity in our sample. In Argentina, Russia, 3, which shows that, controlling for funda- and Ukraine, the default was followed by an mentals, defaults do indeed tend to lower export boom. In the Dominican Republic and credit ­ratings. However, the effect is not Pakistan, it was followed by a sharp decline very large (between one and two notches) in exports.52 and disappears after three years. On the whole, these results confirm the previous 52 It is possible that the behavior of the real exchange result that any effect of default on spreads rate and commodity prices mattered more than the is temporary. default. 688 Journal of Economic Literature, Vol. XLVII (September 2009)

As far as legal sanctions are con- sample and shows the familiar result that cerned, among the eight recent cases, only growth is below average in the year of the Argentina’s default led to large judgments in default episode. The figure also shows that favor of creditors (see section 2). However, in several countries that decided to adopt a a legal challenge to the settlement of the strategy of preemptive rescheduling (Ukraine, debt exchange itself was rejected by New Uruguay, Dominican Republic, and Pakistan) York courts and creditors have been unable growth bottomed out before the ­rescheduling to attach significant assets. After the U.S. year. Argentina and Ecuador, and to lesser Supreme Court rejected an appeal by two extent Russia, suffered severe drops in GDP investment funds to allow the attachment of either during or just after the default. Although reserves of the Central Bank of Argentina growth recovered quickly after most defaults, held in New York in October 2007, the the output losses associated with these crises recovery prospects of investors look increas- could be permanent in the sense that there ingly remote, although litigation continues.53 is not reason to think that they are compen- So far—more than seven years after the sated by higher growth after the crisis (Valerie default—legal action does not seem to have Cerra and Sweta Chaman Saxena 2008). significantly impaired either Argentina’s In sum, the most recent defaults do not economic recovery or its foreign relations. seem to have been significantly penalized This is not to say that litigation has not had through any of the standard channels such any effects at all. The threat of attachment as capital market exclusion, higher borrow- may be one of the reasons why Argentina ing costs, lower exports, or legal or politi- has not issued any sovereign bonds in foreign cal ­sanctions. They did, however, occur in jurisdictions since its 2001 default. Hence, the context of significant economic crises ironically, it was not reputation but the and may have contributed to the depth of threat of legal penalty that seems to have led output losses during these crises, at least to a capital market exclusion of sorts in this in some cases. This—in addition to direct case. However, this does not seem to have costs to the political leadership that steered impaired Argentina’s ability to borrow from the ­countries into default, which usually lost nonresidents (and, more generally, attract power—seems to be the main tangible cost foreign capital as shown in figure 4) by issu- of the most recent defaults. ing bonds in domestic jurisdictions. Finally, figure 7 plots the evolution of GDP 5. Can the Costs of Debt Crises growth (we use local currency real GDP per Be Reduced? capita) around the recent default ­episodes.54 The top left panel plots the average growth As we have seen above, debt crises are performance for the eight countries in the costly, in the sense that they may lead to

53 Following the U.S. Supreme Court rejection of their However, the legal basis for the arbitration attempt is appeal, the plaintiffs returned to the District Court based questionable (Michael Waibel 2007) and, even if investors on a different legal argument. Furthermore, in September win an ICSID award, they may face a similar enforcement 2006, a large group of Italian holders of defaulted problem as the investors that have won judgment claims. Argentine bonds initiated an arbitration procedure before 54 As in the previous figures, we control for country- the International Center for Settlement of Investment specific and year-specific trends by plotting the residuals Disputes (ICSID), an international panel designed to of a regression of the GDP growth over a set of country arbitrate disputes between investors and a sovereign in and year fixed effects (the regression includes all develop- cases in which treaty protections granted under a Bilateral ing countries that had an income per capita greater the Investment Treaty are alleged to have been breached. US$500 in 2000). Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 689

All countries Argentina Dominican Republic .1 .05 .05 .05 0 0 0 .05 .05 − .05 − .1 .1 − − − .15 .15 .1 − − − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Ecuador Moldova Pakistan .05 .05 .02 0 0 0 .05 .02 − − .05 .1 .04 − − − .1 .15 .06 − − − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Russia Ukraine Uruguay .1 .1 .05 .05 0 0 0 .05 .1 .05 − − − .1 .1 −.15 .2 − − − .15 − 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 5 4 3 2 1 0 1 2 3 4 5 − − − − − − − − − − − − − − − Event time Event time Event time

Figure 7. Recent Defaults and GDP Growth

Notes: The figure plots the residuals of a regression that controls for country and year fixed effects and that includes all developing countries that had an income per capita greater than US$500 in the year 2000.

­output declines, financial sector disruptions (SDRM) for countries—focused on ­making and generally a period of capital market the debt renegotiation process smoother exclusion while debt is renegotiated. This and faster, in particular, by mitigating credi- fact motivated a set of proposals, beginning tor coordination failures (see Rogoff and in the 1980s and particularly following the Zettelmeyer 2002 for a history). 1995 Mexican and 1998 Russian crises, to As argued in the previous section, pro- reform the institutions and/or contracts gov- posals in this class can perhaps be criticized erning debt flows and debt renegotiation in (with the benefit of hindsight) for having order to reduce the cost of crises. 55 For the barked up the wrong tree—creditor coordi- most part, these proposals—which climaxed nation failures did not, in the end, turn out to in the ­proposal by management and staff of be a significant impediment to the debt rene- the IMF, in 2001, to create a bankruptcy-type gotiations of the 1998–2005 period. Beyond “sovereign debt restructuring mechanism” questions of empirical relevance, however, proposals that aim to reduce the costs of debt crises raise a deeper issue (Michael P. Dooley 55 For an early proposal, see UNCTAD (1986). 2000; Andrei Shleifer 2003). If sovereign 690 Journal of Economic Literature, Vol. XLVII (September 2009) debt is made possible (and affordable) by the Fundamentally, there could be two rea- costs of default, would the attempt to reduce sons why debt crises are costly. One is that these costs not be counterproductive, in the the ability of market participants to tailor sense of raising the cost of borrowing and/or default punishments to the circumstances of reducing market access, and hence presum- the default is limited by existing institutions ably lowering welfare ex ante? Furthermore, and contractual arrangements, which are to the extent that these costs are endogenous inherited from history. As a result, default (market) responses to the main distortion punishments could both be too blunt, i.e., characterizing sovereign debt—the enforce- fail to adequately discriminate between ment problem—might official attempts to excusable and inexcusable defaults, and be reduce the costs of default not be futile, as socially inefficient. In particular, there could the market will find ways to circumvent these be too much punishment, in the sense that attempts, and create new costs, reputational, the ex ante incentives benefits of punish- or otherwise? In short, are costly crises sim- ment do not fully offset their costs if things ply the inevitable byproduct of the enforce- go wrong. Pitchford and Wright (2007) ment problem? explore this possibility in a calibrated model The answer, given more than twenty years in which defaults are deterred by costly ago in a classic paper by Grossman and Van renegotiation between a country and mul- Huyck (1988), is “in principle, no.” If the only tiple creditors. Suboptimal delays can arise distortion in the relationship between credi- because collective action problems among tors and debtors is the enforcement prob- creditors give rise to prolonged bargaining lem—meaning, in particular, that creditors and “holdouts.”56 Pitchford and Wright’s have full information about relevant actions main finding is that a policy measure that of the debtor and the state of the debtor’s cuts renegotiation time in half (such as the economy—and creditors have access to a introduction of collective action clauses in punishment technology such as reputation or bond contracts or an SDRM) is indeed wel- direct sanctions in the event of default, then fare improving. However, the welfare ben- they will want to exercise this punishment efit is so small as to be negligible. Hence, in only if the debtor defaults in goods states of this type of model, the critiques of Dooley the world. If defaults are “excusable” because (2000) and Shleifer (2003) are at least partly of bad shocks, for example, creditors should vindicated.57 Although cutting negotiation be willing to (costlessly) reschedule the debt. time in half does not have dramatic adverse In other words, the actual payments from ex ante consequences (such as destroying debtors to creditors will mimic an equity con- the ­sovereign debt market), neither does it tract. Default costs will never be observed, have overall big benefits, precisely because because they play a role only “out of equilib- rium” in deterring bad behavior that never actually occurs. 56 See also Haldane et al. (2005) and Pitchford and In the real world, of course, defaults and Wright (2008). debt restructuring do appear to have costs, 57 An alternative class of sovereign debt models focuses so the Grossman and Van Huyck view cannot on protracted renegotiation between a debtor and just one creditor. In Kovrijnykh and Szentes (2007) and Bi apply literally. But why? The answer to this (2008a), the negotiation period ends only after the coun- question has implications for how, and by how try has enjoyed a sequence of good shocks. In Benjamin much, it might be feasible to reduce the costs and Wright (2008), delays may arise because of a shift in bargaining power in favor of the debtor. Unlike Pitchford of debt crises, through policy and institutional and Wright (2007), these papers do not examine the wel- reforms, in a way that raises welfare ex ante. fare trade-offs from lowering renegotiation costs. Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 691 the ex post benefits are balanced by an ex and debt is short term.58 Instead, policy must ante deterioration in borrowing terms. attempt to address those root causes. In prin- An alternative view attributes costly ciple, there are two ways of doing this. First, ­crises to the presence of additional distor- institutions could be created that improve tions—such as incomplete information, or information or provide commitment. This debtor moral hazard—which complicate may enable the development of more com- the standard enforcement problem (Sachs plete contracts between creditors and debt- and Cohen 1982; Douglas Gale and Martin ors (for example, contracts that put a limit Hellwig 1989; Andrew Atkeson 1991; Jeanne on the total debt that a country can issue 2000, 2004; Bolton and Jeanne 2005, 2007). and, hence, prevent the “dilution” of past Suppose, for example, that creditors can- creditors by new creditors; or contracts that not observe the debtor’s capacity to repay. are specifically “equity-like,” such as GDP- In that case, they would not know whether indexed bonds). Alternatively, institutions defaults are “excusable,” and punishments could be created that substitute for more could no longer be waived for some types complete contracts. For example, while an of defaults. A similar problem arises if the SDRM that lowers renegotiation costs across state of the economy is observable but credi- the board may not have a big welfare impact tors cannot tell whether the economy is in (as shown by Pitchford and Wright 2007), poor shape because of debtor actions or this may be different if the SDRM reduces exogenous shocks. Moral hazard problems of renegotiation costs only for countries with this kind can endogenously give rise to debt “excusable” defaults and, hence, does not that is either hard to restructure (Bolton and weaken incentives ex ante (see Sturzenegger Jeanne 2005, 2007) or risky in the sense and Zettelmeyer 2007b, chapter 12, for an that they expose debtors to self-fulfilling overview of proposals in this area). This said, runs via foreign currency or maturity mis- international institutions that play this role matches (Jeanne 2000, 2004; Jean Tirole effectively may be complicated to design and 2003; and Bi 2008b). From the perspective would need to be powerful—and, hence, of the debtor and an individual creditor, this “intrusive” and politically controversial—in is good because it disciplines the debtor and order to be effective. protects the creditor and, hence, makes debt more affordable. At the same time, how- 6. Conclusions ever, it creates an inefficiency ex ante in the sense that the debt structure is suboptimal Sovereign debt has attracted the atten- compared to a situation in which the debtor tion of both economists and legal scholars for could commit to refrain from policy actions many decades. One reason for this fascination that hurt the creditor. comes from an enduring puzzle: how can a The main policy message from this litera- thriving cross-border capital market develop ture is that there is indeed room for public in the absence of enforceable property rights intervention that would both reduce the (or at least with much weaker enforcement costs of debt crises ex post and improve effi- than in other markets)? Another comes from ciency ex ante. However, intervention must be designed carefully or it could backfire. Simply lowering the costs of renegotiation 58 This would be less of a problem if the presence of an across the board, or taxing short-term debt, inefficient debt structure is not only due to institutional failures in the borrowing country but also relates to his- for example, will not do because this ignores torical accidents and path dependence (Borensztein et al. that root cause of why renegotiation is costly 2005; Ricardo Hausmann and Panizza 2003). 692 Journal of Economic Literature, Vol. XLVII (September 2009) the fact the sovereign debt has occasionally punishments from the outside. While it is very given rise to spectacular defaults and crises, difficult to empirically disentangle causes which appear to have been costly for debt- and effects of defaults, there is at least some ors and creditors alike. How do these crises evidence supporting the idea that defaults arise, and through what channels do they may magnify the output drops observed dur- inflict costs on debtors? And finally, what is ing debt crises. Once output costs in line the link between these questions? The fact with this evidence are assumed in param- that defaults lead to costly crises could plau- eterized models of sovereign borrowing, the sibly be the answer—or part of the answer— levels of sovereign debt that can be sustained of why sovereign debt can exist. If so, are in equilibrium rise to more reasonable levels costly crises the inevitable byproduct of sov- compared to models in which capital market ereign debt or could they be eliminated, or penalties are the only punishment. at least mitigated, by changes in the “interna- The critical question is, hence, how defaults tional financial architecture”? In concluding trigger domestic output costs. The most our survey, we briefly summarize what a new popular answer is that a default reveals bad wave of sovereign debt crises, and a new gen- news about either the debtor or the economy, eration of literature on sovereign debt, have leading to capital flight and/or reductions in taught us about these questions. consumption and investment. Alternatively, First, almost three decades after Eaton it may impair the private sector’s ability to and Gersovitz’s pathbreaking contribution, borrow. However, empirical work on testing there still is no fully satisfactory answer to and discriminating between explanations how sovereign debt can exist in the first place. in this class is still in its infancy. A related None of the default punishments that the area that deserves much more attention is classic theory of sovereign debt has focused whether sovereign defaults have adverse on appears to enjoy much empirical backing. domestic consequences beyond the crisis, for Capital exclusion periods are brief; effects example, through effects on credit culture on the cost of borrowing are temporary and and financial development. There also needs small; trade reductions seem to be real but to be more work on the private incentives the literature has not been able to identify of policymakers to default or fight a crisis as the channel through which defaults reduce opposed to the incentives of a social planner. trade; and there is no evidence of diplomatic Finally, while the connection between or military sanctions at least in the postwar costly sovereign debt crises and the existence era. Furthermore, while the legal channel for of a sovereign debt market poses a challenge enforcing debt repayments appeared to gain to policy makers that wish to reduce the ex relevance in the late 1990s—in particular post costs of crises, a new literature suggests by potentially allowing creditors to interfere that this may not be insurmountable. At the with a defaulting country’s international pay- most general level, costly crises must be the ments—this has since turned out to be weak manifestation of an incomplete contracts due to a lack of attachable assets outside the problem. If contracts between investors and debtor’s jurisdiction and because defaulting sovereigns could be structured in a way that debtors have been able to issue new debt solves the incentives problem associated with domestically (including to foreign investors) sovereign borrowing—that is, in a way that at relatively low cost. encourages policies that will keep the bor- If anything, defaults appear to be deterred rower solvent, and punishes repudiation— by the domestic “collateral damage” that then “inexcusable” defaults would never tends to accompany debt crises, rather than occur, only contingent reductions in debt Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 693 services that are envisaged by the contract. ­Management: A Model and a Case Study of Italy.” In Public Debt Management: Theory and History, Contracts could condition on specific debtor ed. 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