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. 651 652 Journal of Economic Literature, Vol. XLVII (September 2009) 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 r easons. 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.