Below is a guest post from Mitu Gulati (Duke, law):
In the wake of the recent drama in the sovereign debt world
in Greece, Dubai, Iceland and elsewhere, memories of the shenanigans that went
on with the recent Ecuadorian debt restructuring have faded. The Ecuadorian government was in the
fairly unique situation of having the funds to pay, but being unwilling to do
so. Their purported rationale: An audit committee whose members the
government had handpicked (including a number of prominent anti debt activists)
had decided that some of Ecuador’s past debts were “illegitimate”. It is not quite clear what Ecuador
meant by the term illegitimate, but it is a good guess that they were trying to
invoke the legal doctrine of Odiousness.
Under customary international law, arguably, the debts of a past
government do not need to be repaid when those debts were used for purposes
adverse to those of the population (and this was done with the knowledge of the
creditors). It would be an
understatement to say that the foundations of this doctrine are shaky as a
matter of international law, let alone whether a domestic court (the debt in
question that Ecuador was complaining about was governed by New York law) would
incorporate it. Interesting though
it is, I’m less interested in the international law aspects of what Ecuador
did, however, than the international relations aspects (Adam Feibelman of
Tulane Law, however, has an interesting piece on this that is coming out soon). Specifically, what is intriguing about
the Ecuador case is that it goes against the conventional wisdom that
sovereigns rarely default when they are able to pay because they want to
preserve their ability to borrow in the future (the “reputational” model of
sovereign borrowing). The
Ecuadorian government, however, decided that its current political needs (there
was strong domestic support for a repudiation of debts and an election was in
the offing) outweighed its future borrowing needs (when perhaps a different
government would be in power anyway).
Most interesting, the Ecuadorian government must have made the
calculation that the reputational costs would not be large.
There are other costs that can accrue to a misbehaving
sovereign debtor though.
Specifically, the multilateral international institutions like the IMF,
the World Bank, the Inter American Development Bank and so on, can get miffed,
particularly if they think that the misbehavior in question imposes negative
externalities on the financial system.
And if they are miffed, that cuts off the sovereign debtor’s source of
emergency financing. In Ecuador’s
case, however, there was nary a peep of disapproval from the
multilaterals. Why not?
In an article just posted on SSRN, economist Arturo Porzecanski
(American University) skewers not only the behavior of the Ecuadorian
government but also that of the multilateral lenders who behaved like sheep in
the wake of what happened. Apart
from being one of the smartest minds in the international finance business and
one of the gurus of emerging markets financing, Arturo writes with great style
and his piece is well worth reading – plus, he says what he thinks, unlike many
others. The piece is titled “When
Bad Things Happen to Good Sovereign Debt Contracts: The Case of Ecuador” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1557040)
Felix Salmon, another delightful writer, who is by far the
most knowledgeable reporter on sovereign debt/emerging market issues, has also
had some wonderful pieces on this. My favorite is titled “Ecuador’s Idiotic
Default” (http://www.portfolio.com/views/blogs/market-movers/2008/12/12/ecuadors-idiotic-default/)
(but I do have to ask Felix: Over
a year later, does Felix still think it was idiotic? I thought it was at the time. But today, in hindsight?)
There was other sheep-like behavior, such as on the part of
the trustee in this case. Lee
Buchheit and I explore this in a related article, “The Coroner’s Inquest.”
At the end of the day, the question is whether Ecuador will
suffer a reputational penalty for its behavior in the longer run (that is, when
it needs to go to the private lending markets for its next bond issue). I confess that I’ve never had much
faith in the ability or willingness of the multilaterals to act appropriately;
they are, after all, political animals.
Ecuador might well have made the smart calculation that the reputational
costs simply would not be that high.
After all, Greece, for all its “book cooking” seems to be borrowing
more.
–Mitu Gulati
***********************
Sovereign defaults are becoming a popular topic here at the Lounge, it seems. Here are some prior related posts:
The Greek Crisis: Economic Meltdown or Mental One?
The Modern Greek Drama: Comedy, Tragedy, or
Both?
The Modern Greek Drama, Part 2
Verge of the Unböring (The Modern Greek
Drama, Part 3)
Is 2010 The Year of Odious Sovereign
Defaults?