Πέμπτη, 1 Ιουλίου 2010

Nine Myths about State Bankruptcies

Going bust is not always the end of the world. In fact, it has its advantages

by Heribert Dieter | 28.06.2010

Eurozone governments did everything in their power to prevent Greece’s bankruptcy. It remains unclear, though, why Brussels and other capitals are so worried about the default of an E.U. country. Bankruptcy is probably the best way to rescue a national economy from excessive debt. The current discussion is rife with misunderstandings.

One. State bankruptcies are rare

This is not true—unfortunately. Economic history is replete with instances of national bankruptcy. A few countries have even gone bankrupt several times, though others have never had to take this step. Between 1550 and 1800 France declared insolvency eight times, and French kings were fond of solving the problem of excessive debt by beheading their most important creditors. 250 cases of state bankruptcy were recorded for the period 1820–2004. And it was not always the same national economies, either: a total of 106 different states defaulted in this period.
Mexico’s default in 1982 was followed by 70 other national bankruptcies, of which 34 involved African countries and 29 struck states in Latin America. Prior to the Latin American debt crisis, it was commonly believed that states could not become insolvent. In the late 1970s, Walter Wriston, longstanding CEO of Citigroup and one of the most powerful bankers in the world, remarked tersely: “Countries do not go bankrupt.” In formal terms, he was right. States remain solvent if their debts are not denominated in a foreign currency. But after considering whether the political and economic costs are higher for servicing the debt or for defaulting, the political leaders of a country may decide to halt payments of interest and principal. In other words, states can indeed become insolvent. In the midst of a crisis, though, their actions are above all determined by an unwillingness to pay rather than an inability: governments, especially democratically elected ones, are often reluctant to impose new sacrifices on their citizens.
Russia’s bankruptcy in 1998 also caused considerable turmoil, despite the fact that Moscow continued to pay interest on foreign currency bonds and only temporarily halted payments on just 40 billion dollars worth of ruble-based bonds. The Russian default in 1998 was followed by a number of state insolvencies. The governments of Ukraine, Pakistan, Ecuador, Uruguay and, most famously, Argentina decided not to service their national debt.
Greece is among the countries that have declared bankruptcy several times in the past. In This Time Is Different, which has quickly established itself as a standard work in the field, U.S. economists Carmen Reinhart and Kenneth Rogoff demonstrate that Greece was in a constant state of default for over a hundred years. After independence in 1829, Athens was forced to declare bankruptcy four times and also had to accept the partial limitations imposed on its sovereignty by its creditor, Great Britain. Countries such as Austria and Spain have often failed to service their debts on the agreed scale.

Two. State bankruptcies destabilize financial markets

There would, of course, be less turbulence in financial markets if states took on only modest levels of debt or if they assumed no debt at all. However, if governments decide to borrow money on a massive scale, there must at least be the possibility of a state bankruptcy. The circumstances surrounding a national bankruptcy and the associated costs are the reason why creditors make capital available to governments in the first place. In contrast to the loans made to companies, there is no orderly bankruptcy procedure for sovereign debtors. Governments service their debts because the costs of not servicing them are higher. However, there have been repeated cases of governments favoring a national bankruptcy over debt repayment in the past.
States that fall into arrears face two primary costs. First, the tarnishing of their reputation as debtors and the related higher costs of new debt (reputational costs); and, second, the increase in the cost of international trade as well as consequences that can include the exclusion from global markets. The main motivation for sovereign debtors to service their debts is the fear that they will remain shut off from international financial markets in the future. Nevertheless—and surprisingly enough—empirical studies have not shown this to be a particularly high risk. In most cases, it cannot be demonstrated that states suffer any negative effects one or two years after defaulting. Argentina, of course, is an exception.

Three. Modern financial markets protect against state bankruptcy

Wrong. There were fewer loan providers in financial markets in the past than exist today. During the Latin American debt crisis in the early 1980s, the main creditors of Argentina, Brazil, and Mexico were a handful of American banks. These states‘ insolvencies led, not least, to changes in the way loans were awarded. Today states no longer raise money by taking out massive bank loans; they issue bonds and, as a consequence, have many thousands of creditors. It was assumed that, due to this change, states would be more likely to service their debts in the future. After all, the shift from loans to bonds brought a significant increase in the cost of restructuring debt. But this assumption has proved mistaken. Debtors can also resort to alternative financing models such as bond issues on domestic markets, aid from neighboring states and loans from other states.

Four. External players can eliminate the risk of a state bankruptcy

Wrong. Although some states have never fallen into arrears and are regarded as low-risk debtors, this status is not the result of external guarantees, but of sustainable fiscal policies designed to minimize risks. External players can eliminate the risk of a national bankruptcy only if they assume liability for the consequences of the jeopardized country’s fiscal policy and, in cases of doubt, take on state debts. Since this policy does not appear to make much political or economic sense in Europe (or in other regions in the world), the providers of guarantees attempt to ensure that national debts are repaid by dictating strict conditions. But this process is extremely risky: external players are almost never in the position to make political decisions for a crisis-ridden country and, at the same time, to hand over responsibility for the success of a reform program to domestic players. In other words: as they stipulate conditions, they systematically strip the countries of their independence and dignity.

Five. The declaration of bankruptcy always plunges a national economy into a long crisis

This can happen, but it does not necessarily have to. The central question is whether bankruptcy is used to bring down a country’s debt to levels where it can be serviced and new investments can be financed. Two well-known cases of state bankruptcy in recent history were followed by long phases of economic expansion. Russia’s default in 1998 marked the end of a phase of economic decline and the beginning of an upswing that lasted until the subprime financial crisis. Just after bankruptcy, Russia’s economic output matched that of Belgium, but it grew rapidly in the ensuing period. Whereas Russia’s economic output was just 196 billion dollars in 1999, it reached 1,680 billion dollars in 2008. Since Russia’s declaration of bankruptcy, its economic output, expressed in U.S. dollars, has soared eightfold.
Argentina underwent a similarly positive development, entering a phase of rapid economic growth after defaulting on its debt. Although the Argentine economy shrank between 1998 and 2002, economic output rose sharply after payments to its creditors were discontinued. Starting in 2003, the Argentine economy expanded at real annual rates of about nine percent. Argentine economic output rose from 102 billion dollars in 2002 to 328 billion dollars in 2008.
But two factors had an important impact in the case of Argentina. First of all, there was a dramatic devaluation of the Argentine currency, which had previously been pegged one-to-one to the American dollar. This depreciation substantially improved the capability of Argentine companies to compete on price in global and domestic markets. Second, when the exchange rate was still pegged to the dollar, owners of Argentine monetary assets transferred large sums to dollar-denominated accounts outside Argentina. After devaluation, this money flowed back into the country. To sum up, two elements proved advantageous in the case of Argentina and Russia: currency devaluation ensured competitiveness, and creditors (involuntarily) waived some of their claims.

Six. A state bankruptcy could weaken the euro

In the debate on Greek aid, one often hears the argument that a state bankruptcy in the eurozone would weaken the euro. But why? This assumption is presumably based on historical experience: when Argentina defaulted, its currency declined in value, not least because capital flowed out of the crisis-ridden country, putting pressure on the exchange rate. But circumstances are different in a currency union. A single state bankruptcy, particularly that of a tiny economy, will not have any lasting effect on the value of the issue denomination. The long-term stability of a common currency is jeopardized only if the bank of issue assumes liability for the debts incurred by the member states of the currency union—as happened in the E.U. in May 2010.
On the other hand, a national bankruptcy sends a clear signal that investors must share the cost of restructuring debt. The effect of a Greek bankruptcy on the euro would have been as negligible as General Motor’s Chapter 11 filing on the dollar. A monetary union offers the greatest stability when it is not attached to a fiscal union and mutual liability for deficits. The latter undermines trust in the common currency and leads to wrong incentives for debtor states

Seven. In the event of a state bankruptcy, creditors lose all their capital

This is only partly true. A default is usually followed by efforts to restructure national debt, also called debt conversion. This restructuring is usually linked to a partial waiver of debt. In each individual case, the amount of debt to be waived is set by creditors in restructuring negotiations. In 1998, for example, the domestic holders of ruble-denominated bonds were forced to waive 45 percent of debt; foreign creditors waived 61 percent. In Ukraine, domestic investors received almost all their money back (93 percent of the original claims), while foreign holders of debt got back only 44 percent of their capital. The most dramatic national bankruptcy in recent history was Argentina: foreign bond holders who accepted the 2005 debt restructuring offer from the Argentine government were forced to relinquish 73 percent of their claims.
Bonds from high-risk countries can nevertheless prove a worthwhile investment when compared to other securities such as German federal bonds. During the 1990s, for instance, the Russian state was forced to pay a very high risk premium. Despite the debt waiver that came later, many foreign creditors profited from their engagement in Russia—provided they held investments for a long enough time.

Eight. A state bankruptcy can be prevented by new loans

Au contraire. Reform forces are only mobilized by the prospect of a default and the related negative consequences for the national economy. New loans from foreign countries, especially state loans, can repeatedly delay efforts to overcome well-known problems, as happened in Russia. In early 1999, former Russian finance minister Boris Fyodorow addressed this problem, saying: “Foreign money has only helped incompetent people to buy time to do nothing. . . Giving this government more money will not solve a single economic problem in Russia.”
And today? Fyodorow’s assessment is every bit as true for the crisis-ridden countries in Europe, particularly for Greece. Greece’s structural problems will not be solved by new loans, nor will Greek companies be made more competitive by the measures dictated by the International Monetary Fund and the European Union.
New loans only reinforce structures that are ultimately unsustainable. This was the case in 1990s Russia, when Boris Yeltsin was at the helm. As the veteran German journalist Christian Schmidt-Häuer wrote in Die Zeit at the time: “Why are we helping the mafia? Yeltsin’s gang is corrupt. The West knew it—and gave them billions.” In Argentina, too, state loans from foreign countries only served to delay the inevitable scrapping of the old currency regime. With the exchange rate pegged at one peso per dollar, Argentina was unable to compete, and its economic upswing began only after this peg was lifted.

Nine. Greece will be the last case of near bankruptcy

This is unfortunately also wrong. By the end of the current decade, state debt levels in industrial countries will worsen dramatically. Developing and emerging nations, on the other hand, will face fewer problems with state budgets, primarily because of positive growth projections and more advantageous demographic developments. According to a spring 2010 Deutsche Bank forecast, national debt in industrial countries is expected to grow from 76 percent of economic output in 2007 to 133 percent in 2020, while developing countries should be able to reduce average national debt levels from 42 percent to 35 percent in the same period. The rescue packages for the financial industry and mounting demographic pressures will bring hard times for industrial countries. Against this backdrop, it is clear that Greece is not an exception, but the new rule. The candidates for future crises can be found, not in Latin America, but in America and Europe.
Up to now, the debate has focused mainly on the possibility of a Greek default, but in the coming decade large national economies, such as those of the United Kingdom, the United States and Japan, will be pushed to the brink of insolvency. At the start of the current crisis, observers were already ridiculing London on the Thames as “Reykjavik on the Thames.” In just a few years, Japan, once an economic wonderland, will stagger under debt levels unprecedented for an industrial state during peacetime. We will be confronted with many more industrial states going bust in the future.

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