Yves here. The US has long been indifferent to the effect of its interest rate policies on the rest of the world, even though analysts and even central bankers have warned how destabilizing US interest rate changes are to small economies with large import/export sectors, dollarization, or worse, meaningfully borrowing in dollars. As we wrote in 2015:
As a result of the US’s push over decades to make the world safe for America’s investment bankers, capital flows across borders easily, and some top experts contend, too easily. Carmen Reinhart and Ken Rogoff, in their work on 800 years of financial crises, found that high levels of international capital flows were strongly correlated with more frequent and severe financial crises. In 2011, Claudio Borio and Piti Disyatat published an extremely important analysis of the crisis which shredded the Bernanke “global savings glut” thesis. It instead found that the culprit was excessive financial elasticity, which basically means deregulation and the resulting high level of cross-border capital flows.
Yet the Fed tries to deny the implications of being the steward of the world’s reserve currency in a world of extremely nimble investors who have large pools of funds at their disposal. ZIRP and QE have made the US a major funder of a global carry trade. Remember when global market activity could be summed up by “risk on-risk off” reactions to news? One of the big beneficiaries of “risk on” trades were emerging economies, particularly ones with relatively high domestic interest rates. And when investors got spooked, they’d be the canaries in the coalmine, suffering the most when the tide of money sloshed back to seemingly safer havens.
The Fed’s response to considerable unhappiness of central bankers in the countries that are exposed to the moods of hot capitalists has been to try to deny that the Fed has anything to do with these shifts, or to try to blame the other countries, as in it’s their fault that the money left.
Bernanke did back off on his plan to normalize interest rates in 2014, not due to protests from emerging economies, but due to the so-called taper tantrum, as in an investor hissy.
This post describes how the coming developing economy crisis resembles and differs from past ones and give insight into how debt negotiation dynamics lead to less than ideal outcomes.
By Lynn Parramore, Senior Research Analyst, Institute of New Economic Thinking. Published at the Institute for New Economic Thinking website
People are waking up to discover that another international debt crisis of enormous proportions looms on the horizon of a scale not seen since the early 1980s, after which Latin America and Africa slogged through a “lost decade.” Implosions of this magnitude can wipe out years of progress in health, education, and social stability. Yet not many people understand why and how this is happening.
As a new crisis gains momentum, economist Martin Guzman, former Minister of the Economy of Argentina and co-president of Columbia University’s Initiative for Policy Dialogue offers his perspective on what has gone wrong and what can be done to address it. In his view, you can’t understand debt crises without confronting the power dynamics at play.
Lynn Parramore: What has happened to suddenly create this alarming situation?
Martin Guzman: What we are seeing is a looming debt crisis in the Global South. A series of events led us into this situation. I’ll distinguish three critical ones.
To understand debt dynamics in the Global South, it’s always essential to look at what happens with monetary policies in the North.
The first event critical to understanding this looming debt crisis took place a decade and a half ago. The response to the U.S. financial crisis entailed a massive creation of liquidity through quantitative easing. That liquidity became global, as is always the case in a world economy with capital mobility. In a world of zero interest rates, there was a “search for yield,” a peculiar concept that involves searching for compensation above global market rates. In a competitive market, that would, of course, imply a particular choice of risk and return that would not mean a higher risk-adjusted return.
We saw a significant number of countries having access, for the first time, to international credit markets, but at rates that acknowledged risks. This was the case in African nations that were borrowing at 8-10% interest rates when the treasury bonds from advanced economies were yielding rates close to zero — and in some cases even negative. Countries that formerly had been part of the group of Highly Indebted Poor Countries (HIPCs), such as Ghana or Zambia, both now suffering a debt crisis, managed to place bonds abroad, but at high rates.
We also had countries re-accessing international credit markets. The most notable case was Argentina in 2016. After the end of a long dispute in the U.S. courts with the vulture funds, which, included 15 years of exclusion from international private credit markets, it began to borrow again at average rates (in U.S. dollars) of 7%. This was happening when the global interest rates were still close to zero.
The second critical event was Covid-19. The pandemic led to increases in global debt as countries saw their tax revenues drop and a need for increased spending. For advanced economies, this did not have sustainability consequences but mostly intergenerational consequences: future generations would pay off debts that were contracted today. But for several countries in the Global South, this situation created immediate debt distress.
The last blow was the war in Ukraine, which made inflation the top concern for economic authorities all over the world. The response from advanced economies’ central banks featured interest rate hikes and the undoing of quantitative easing — what’s been called “quantitative tightening.” This means less and more expensive liquidity.
Central banks have their own mandates, and they don’t consider the international spillovers of their actions. For the Global South, it becomes more difficult to roll over debts—and in many cases, it becomes unsustainable. With no access to credit markets to refinance the debts, paying them down would imply destabilizing economic and social dynamics, meaning deeper recessions, more unemployment, and more inflation.
These outcomes show how the policies of a few powerful nations have significant repercussions for the rest of the world.
LP: In what ways does this looming debt problem differ from what happened in 2008 and the famous debt problems of the 1980s, often said to have led to a “lost decade” in many parts of the world?
MG: There are similarities as well as important differences between what is going on now and the 1980s. In both cases, the troubles were preceded by a period of growing global liquidity that was then abruptly reversed. In the 1970s, the oil price shocks led to massive trade surpluses for oil-exporting countries and deficits for the oil-importing ones. Those surpluses were the basis of the loans extended to the deficit countries. In 1981, the Fed responded to inflation by increasing interest rates up to a peak of 20%. Today, the Fed has also abruptly increased rates, but not as much. In both cases, contractionary monetary policies in advanced economies created troubles elsewhere.
The first key difference is that the 1980s debt crisis included distress in a different group of economies than we see now. Most of Eastern Europe was in crisis—first Poland, then Romania, Hungary, and Yugoslavia requested IMF financing at the beginning of the decade. And it hit large economies of Latin America, including Brazil and Mexico. The IMF lending reached what for the time were record amounts, and those funds were used to bail out private creditors.
The second key difference with respect to the 1980s is the composition of creditors and the size of their exposure. Back then, international private financing to sovereign countries came mostly in the form of commercial bank loans. Bank exposures, especially from the U.S. and Japan, were so large that a wave of sovereign defaults in Latin America would have created a financial crisis in those two advanced economies and almost surely it would have turned into a global crisis.
I witnessed something interesting years ago while teaching at the Trento Summer School, an amazing academic school for Ph.D. students created by the great Swedish economist Axel Leijonhufvud. In his lecture, a retired former economist of the NY Fed who was in charge of the Euro-dollar syndicated loan market and dealt with the debt crisis in Latin America from that position, explained to us very candidly that the American banks were so exposed that the U.S. government had to exercise its foreign policy for the region so as to make sure there would not be a wave of defaults in the countries from that region. They did so for the entire decade, which was as long as it took to get to a point at which accepting some losses would not bankrupt the system. We had Latin American economists in the audience who had been involved in policymaking in their countries during that decade. They had seen firsthand how being deprived of foreign exchange led to a lost decade for growth and in some cases hyperinflation, like in Argentina. I remember the gloomy faces. When governments borrow in foreign currency, they must be aware that the resolution of sovereign debt crises is a geo-political process. That was true in the 1980s and it’s true now, although the composition of creditors and associated geopolitics is different today.
The events of the 1980s changed the international financial system and set the stage for bonded debt as the main source of international private financing to sovereigns. This takes us to the third key difference: the universe of private creditors is more fragmented today and more complex to coordinate. This also means that the relations between debtors, private creditors, and official creditors are different.
With bonded debt, restructurings may also involve disputes with holders of derivative contracts, arbitration award holders, and other categories of what we should call “claimants of state resources” rather than creditors.
The last decade and a half has featured a significant increase in the incidence of new official bilateral creditors, referred to as the ‘non-Paris club creditors’ as opposed to the established group of major creditor countries which have coordinated their dealings with debtor countries for nearly 70 years, meeting regularly in Paris. This new group has China as the major player but also includes other emerging official creditors such as India, South Africa, and Saudi Arabia.
This all means that the group of debtors in situations of vulnerability, the exposure of the international financial system, and the group of creditors are all different now than in the 1980s. As a consequence, the current crisis will likely be less systemic, but it will be bad for those countries that suffer from it. The solution will require a distribution of debt write-downs among classes of creditors that are interacting for the first time in history and have competing interests.
For resolving countries’ debt crises, neither then nor now is there a multinational system for debt restructuring. This is a massive deficiency of the international financial architecture—not a casual one, but a result of international power relations.
LP: You studied international economics for years in your scholarly life. Then you were asked to actually lead negotiations with your country’s creditors. How have these two experiences affected your understanding of the international debt problem? Any special insights that helped from academic theory?
MG: When tackling a sovereign debt crisis as a policymaker, there are two key issues that must be clearly defined.
First, what kind of debt restructuring operation would be consistent with the goal of restoring debt sustainability, meaning restoring conditions for implementing an economic policy plan that is conducive to economic recovery and sets conditions for sustained progress?
Second, you need a view of the power dynamics at play, both internationally and domestically. Every sovereign debt restructuring is a political process that involves conflict, as there are distributional consequences from those processes. There are also efficiency implications that may not fall only on individual stakeholders; those broader processes not only affect how the pie is distributed but also the size of the pie that will be divided among the debtor and its creditors.
Understanding technical issues helps. A critical stone of every debt restructuring process is the debt sustainability analysis that identifies whether the debt is sustainable, and, if the answer is negative, computes the amount of relief necessary to restore sustainability. You need to grasp both the theory and the practice of debt sustainability analysis to craft an appropriate strategy.
Consider the case of Argentina’s 2020 debt restructuring. In 2018, after two years of massive borrowing in foreign currency, mostly under New York law, the country lost access to international credit markets again. The government immediately resorted to the IMF, which, with the political support of the Trump administration, provided the largest loan in the history of the institution. A USD 50 billion loan was approved, then increased to USD 57 billion, of which almost USD 45 billion was disbursed until the IMF stopped when the previous Argentine president lost in the primary elections of 2019 —another hint that the loan was political in nature. (For the record, the newly elected President Fernandez made it clear immediately after taking office that the government did not want to increase its debt with the IMF, and hence would not seek to receive the additional USD 12 billion that had been approved.)
In December 2019 we took office and I became the country’s Minister of Economy. We immediately began to address the debt crisis. We had conducted a debt sustainability analysis that indicated that foreign-currency public debt was unsustainable and that a debt restructuring with a significant cut in scheduled payments was a necessary condition for restoring growth. At the time, the economy was in freefall.
A debt sustainability analysis is supposed to anchor expectations. But in the context of vested interests, in which the stakes are on the order of dozens of billions of dollars, lobbying is intense and may be highly effective to delegitimize the analysis produced by a debtor government, even if it’s based on state-of-the-art theoretical and empirical literature and has the recognition of top international experts. So I asked the IMF to conduct an analysis of debt sustainability. It was supposed to provide guidelines that could anchor expectations both for creditors and for the domestic political system.
The initial response from a part of the IMF staff was puzzling. Some said we can’t do it because your country is not under an IMF-supported program (the previous program had completely failed and had already been dismissed, a failure that was recognized years later, in 2022, by the IMF Staff in its ex-post Program Evaluation), and so we cannot know what the policy parameters that need to feed the debt sustainability analysis will be. That was just a ridiculous stance to me. My response was that we are a sovereign nation, and as such we could provide the information on what policies we were going to implement, even if the country was not under an IMF-supported program. There were some discussions, and I even flew to Washington D.C. from the G-20 meetings in Saudi Arabia in February 2020 to move forward in what was looking like a negotiation on doing a debt sustainability analysis—which should be the right of any member of the IMF. Finally, the IMF management made the decision to produce a “technical analysis of debt sustainability” at our request. It was remarkably similar to the one produced by Argentina’s government.
Creditors didn’t like it. They complained a lot. Some creditors explicitly told me that the staff at the U.S. Treasury Department was telling them not to pay attention to the IMF document. In that context, it was hard to anchor creditors’ expectations, but there was a very important sense in which the IMF analysis of debt sustainability helped: it aided us in dealing with what I would call a “domestic political economy” problem, meaning that our own domestic political system, for different reasons, was not prepared to face a tough negotiation and there were signals to creditors that the government would not be willing to remain in a situation of default, even if that entailed a very bad deal. Having the IMF say what they said on Argentina’s debt unsustainability strengthened the power of the negotiating team to deal with the internal pressures. It’s not easy for some domestic constituencies to be placed to the right of the IMF.
LP: In what ways do you think economic theory and legal practice are changing in response to the forces you mention above?
MG: Canonical sovereign debt models have a hard time accounting for or explaining the facts on sovereign debt defaults, restructurings, and returns. The standard economic literature on sovereign debt doesn’t incorporate a fundamental dimension for understanding sovereign debt dynamics: power.
A recent paper by Josefin Meyer, Carmen Reinhart, and Christoph Trebesch, “Sovereign Bonds since Waterloo,” analyzes data on ex-post returns of sovereign debt—which accounts for losses associated with defaults and restructurings— since Napoleon’s defeat at Waterloo in 1815—an event that marks a wave of creation of sovereign nations—and finds evidence that sheds light on how the system actually works: the average real ex-post returns from foreign-currency denominated government bonds significantly outperform the U.S. or U.K. bonds by an order of magnitude of 400 basis points on average, and in most Latin American countries the margin is even larger. For instance, the average real ex-post return of Argentina’s bonds over the last 140 years is more than 500 basis points higher than a U.S. treasury bond, even accounting for all the defaults.
What explains this? One possible explanation is that private creditors are risk averse, hence models that assume that they are risk-neutral or that risks are sufficiently diversified can’t explain this result. I don’t find this explanation very plausible, because in such a case we should observe that less risk-averse creditors or those who are better at managing risk become the bond “marginal buyers.” To me, that evidence suggests that there are rents, and that has to do with the way the system works. It’s the way power shapes the system – something that the economics literature has not explored in depth. In other words, power in the system readjusts the returns in favor of the creditors.
The role of power should be a central part of a research agenda in economics in general, and for sovereign debt specifically.
When it comes to practice, there has been an evolution related to power dynamics, as I described before. Let me highlight two issues that matter for the practice of sovereign debt crisis resolution today.
The first one is related to creditor coordination. We still do not have anything remotely close to a bankruptcy framework for sovereigns, so negotiations happen in the context of an international non-system. Since the end of the Bretton Woods system, we have seen bad outcomes when it comes to resolving debt crises. The current non-system produces incentives that delay the initiation of restructurings, and when they are done, they generally come with insufficient relief to allow the countries to restore growth. The literature refers to this problem as the “too little and too late” syndrome.
Top experts have been demanding the creation of a multinational system for sovereign debt restructuring for a long time. The 2009 Stiglitz’s Report for the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System is clear in this respect and anticipates the troubles that we are seeing. In 2001, even the IMF pushed a Sovereign Debt Restructuring Mechanism proposal. While it would have been difficult for debtor countries to accept a creditor as the judge, the initiative did not gather the shareholders’ support, or at least the support of the IMF’s main shareholder, which would have had to take it to Congress for a vote that would allow a change in the IMF Articles of Agreement.
The latest progress for coordinating private bondholders was the endorsement of enhanced collective action clauses that make it easier to act without unanimity from creditors and makes vulture funds’ holdout behavior less profitable in expectation. These measures helped but weren’t nearly enough to guarantee effective restructurings. We tested them for the first time in Argentina’s 2020 restructuring.
The second issue that merits mention relates to the IMF. A few days ago, on April 3rd, Columbia University’s Initiative for Policy Dialogue hosted a roundtable of experts on sovereign debt at the Columbia Business School. The roundtable was joined by representatives of debtor countries, the U.S. Treasury Department, China, private creditors, the IMF, and academics and practitioners. We had some very insightful discussions. Debtor countries were complaining that when the IMF produces a debt sustainability analysis, it remains secret until the IMF’s Executive Board approves the IMF-supported program. Most of the policymakers do not know that they can make all the information publicly available—they are nudged or pressed not to do it. As member countries, they could request the IMF to perform a debt sustainability analysis as technical assistance and get it published even if there are no negotiations towards an IMF-supported program. Countries could also make public all the memorandums that constitute the IMF-supported programs before they are taken to the Executive Board for approval. That’s how things should be done. Societies should have a chance for public scrutiny of deals between a government and the IMF staff that have massive consequences for their development.
It’s peculiar that the IMF wants the programs to be “owned” by the country, but the institution doesn’t have a preference for transparency. If you want the people to own the program, you should allow the people to see the program.
In 2022 in Argentina, immediately after we reached a deal with the IMF’s staff to refinance the $45 billion debt borrowed in 2018-2019, all the memoranda were submitted to the National Congress. In 2020 I presented a bill that makes Congressional approval mandatory for having any financing program with the IMF. It was passed in 2021 almost unanimously. This was the first country to adopt a legal framework of this kind, and I believe others would do well in doing the same.