Authority and Discretion Over Troubled Sovereign Debt: Who Has Voice?

By Leslie Elliott Armijo and Prateek Sood

Global concern over the recent acrimonious debate surrounding raising the United States’ debt ceiling – and the tenuous relief following a long awaited agreement –  illustrates the US dollar’s centrality in the national and world economies.

While there would be an enormous cost to the reputation and leadership capabilities of the United States if a default were to occur, a rescue would nonetheless follow. The International Monetary Fund (IMF), the Group of 20 (G20) – including China, and perhaps even Russia – and all other financial power centers would pull together to try to halt a meltdown. Even Wall Street has created a precautionary plan to allow Treasury securities to continue trading in the event of a default.

However, the same is not true for most defaulting sovereign debtors in the Global South.

In a recent essay, we identify a persistent bias in the international financial architecture against Global South economies. The bias is particularly visible during periods of debt stress and sovereign debt restructurings. International debt crises imply the breakdown of standard procedures and consequent exercise of discretion by those able to wield authority. Officials from the Global North, who exercise effective control of the institutions of peak financial crisis management, are most politically responsive to their own citizens and private financial interests. Thus, Global South economies experience a problem of voice precisely at the point of sovereign default, when they are most vulnerable.

Background

In the 1920s and 1930s, both big banks and sovereign countries defaulted on their debts, to depositors and bondholders respectively, sending the world economy into over a decade of depression and volatility ended only by the carnage—and the massive demand stimulus—of World War II. In an influential 1973 book, economic historian Charles Kindleberger concluded that, in a universe of sovereign states each pursuing its own mutually incompatible path, the principal underlying problem during the interwar period had been the lack of active leadership by the major financial power of the day.

Kindleberger’s insights, subsequently labeled “hegemonic stability theory,” explained and legitimated the system that evolved after the war, which was that balance of payments rescues would be a de facto collaboration between the IMF and the economic team of the key currency power, the US. At the Bretton Woods conference in 1944, the major Western victors except the Soviet Union collaborated to construct new multilateral institutions, intended to prevent a repeat of the 1930s by promoting collective management of global economic challenges. On the financial and monetary side, the principal formal institutions, the IMF and World Bank, were helpful but insufficiently powerful to restore exchange stability among the major economies. The US, reluctantly supported by its major Western allies, quickly filled the gap with the Marshall Plan and other ad hoc interventions.

The current system improves over that of the interwar period: systemic financial crises have been prevented or halted, generating better outcomes for the global economy. Yet, the institutions of postwar global economic governance nonetheless perpetuate biases. While the IMF serves all its member nations, advanced economies continue to be overrepresented in the decision-making processes. The US alone holds enough voting power to veto structurally important changes to the IMF, such as amending articles of agreement, the allocation of voting shares, or quota increases. Moreover, this melding of multilateral with unilateral crisis management has meant that the public good of preventing global financial meltdown operates with informal steering by one interested party, the US government, which prioritizes sovereign debt settlements that differentially favor US financial interests. 

Our essay highlights the implicit grant of discretion to Northern crisis managers, whose judgments reflect their national biases. A look at three infamous debt episodes, from Latin America to East Asia, and back again to Argentina, traces how ad hoc decision-making muted the voices of sovereign borrowers when default loomed.

The Latin American Debt Crisis (1982-1989) 

In the 1950s-1970s, Latin American countries pursued policies of import substitution industrialization, resulting in rapid economic growth, but also foreign indebtedness, as imports of capital goods soared, especially of heavy machinery to outfit the new factories producing mostly consumer goods. Beginning in 1979, the US Federal Reserve, tasked with managing domestic monetary policy, began to raise US interest rates. Panicky American banks recalled their loans throughout the region, provoking the defaults they feared and resulting in Mexico’s sovereign default in August 1982. Loans to Latin America by nine large American banks, over 180 percent of their net worth, threatened a US banking crisis. The coordinated response by the IMF and US authorities involved regulatory forbearance by the latter and large new loans to debtor nations to ensure continued debt servicing, resulting in large net outflows from Latin America during the entire “lost decade,” with the crisis deemed resolved when Northern private banks could get the bad loans off their books. Crucially, when debtor nations reciprocally attempted to coordinate, they were branded as a cartel and offered better deals to defect.

Asian Financial Crisis (1997-1999)

Capital account liberalization in East Asia in the 1990s, promoted by the IMF and even more strongly by the US government, generated under-monitored foreign borrowing by the private sector. In the context of fixed exchange rates and well-informed currency speculation against the Thai baht, the Thai central bank in 1997 exhausted its foreign currency reserves, forcing it to turn to the IMF. Once again, fearful private investors assumed similar conditions in neighboring countries, provoking a regional crisis. The IMF imposed a standard package of public sector austerity as the condition for its loans, just as it had in Latin America. However, an expert chorus from the region and elsewhere observed that the cure was ill-advised, given that East Asian governments lacked the chronic public deficits found in Latin America in the 1970s. Malaysia, supported by Japan, the only creditor country from Asia, challenged the prescription, opting instead for capital controls. Meanwhile, and as with Latin America in the 1980s, private bank creditors successfully pressured the US and the IMF to oblige debtor governments to assume responsibility for the foreign debts of their private sectors. The crisis was again considered resolved when Northern banks were out of danger.

The Argentine Debt Impasse (2002-2016)

In 1991, Argentina adopted a currency board exchange system, tying its currency to the US dollar by law. The program ended inflation and restarted growth, but at the medium-term cost of intense overvaluation of the peso, resulting in slowing growth, rising unemployment and foreign indebtedness. Argentina defaulted in late 2001 and broke the currency link in January 2002. Distrusting the IMF, successive presidents from the left ran their own debt negotiations reaching voluntary settlements with the owners of 93 percent of their outstanding bonds. Once again seeking credibility with global markets via hand-tying measures, the Argentine government had issued replacement bonds with a clause running until 2014 that protected bondholders from losing out if subsequent creditors received a better deal. Junk-bond investors won an injunction based on the ‘equal footing’ clause to prevent any payments to the holders of rescheduled bonds unless an agreement was also reached with the so-called “vulture funds,” which were demanding the original bonds’ full face-value. Although this contravened the intent of the clause, American authorities declined to intervene aggressively, despite the significant negative impacts on both the country of Argentina, which was unable to engage in most international financial transactions for years, and its mostly Southern European exchange bondholders, who were unable to access their previously rescheduled payments from Argentina.

Ways forward

As compared to the chaos of the 1930s, the still-evolving postwar system of global economic governance is an improvement. Tweaking current institutions and informal practices to provide more space for defaulting Southern governments to make their case—even in the midst of urgent crisis management—could make future debt reschedulings fairer, without undercutting hard-won global financial stability.

Specific solutions have been proposed and debated for decades in various forums including the IMF, United Nations Conference on Trade and Development and think tanks. However, the same power imbalances that have influenced the allocation of default costs unfairly towards debtors, continue to inhibit the imposition of many potential solutions. Thus, paths forward require not only creative solutions on how to balance voice and improve restructuring outcomes, but also a better understanding of the politics behind the management of sovereign defaults.

Prateek Sood works in the Strategic Policy and Innovation Unit at the City of Toronto. He holds a B.A. in Economics and International Studies from Simon Fraser University, and an M.A. in Global Development Studies from Queen’s University.

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