SOVEREIGN DEBT DEFAULTS HOW TO
The population of the troubled country usually pays the biggest price for the swings of capital flows simply because the state ends up bankrupt.ĭespite officials and individual players in the market being well aware of such issues, no international consensus exists as to how to establish a restructuring mechanism in a situation of debt crisis. Within a widespread and diversified creditor community, individual investors, acting rationally, may obstruct a solid and orderly debt restructuring, even under a sound national insolvency procedure. Such lone wolf investors can actually hinder the structuring of an agreement should they decide to “free-ride.” Moreover, individual investors are more prone to sue the debtor should the debt not be serviced, as several examples have confirmed. Another problem is that while creditors have no choice but to negotiate debt restructuring with a state, some obstinate individual (“holdouts”) investors may use strategies that are counterproductive to macro policies as a whole. This ‘run on the banks’ type of reaction transforms financial crises into potential defaults. One of these collective action problems is the ‘rush-to-exit problem,’ in which investors tend to lose confidence in the sustainability of a debtor economy and try to withdraw their investments all at once. Each creditor has an incentive to act in its own perceived self-interest, which usually results in suboptimal outcomes for the group of creditors. Recent times have witnessed the emergence of ‘collective action’ problems, which pose systemic worries for policymakers. Though offering a seemingly attractive environment for investment due to their booming economic activity, which is largely driven by credit, emerging market economies are usually more predisposed and susceptible to sovereign defaults. This lack of balanced legislation on responsibility encourages reckless creditor behaviour and encourages a dangerous cyclical pattern in global credit markets. Consequently, in the vast majority of liquidity/insolvency crises the risk is effectively borne by debtors. Yet, no international mechanism has been established to involve creditors in crisis resolution within the global credit market. Addressing this issue became part of the official agenda following spectacular sovereign defaults, such as that of Argentina at the beginning of the century.Ĭreditors bear a significant share of the risk of debtor default in almost all states’ domestic insolvency legislation. The debt crisis in Latin America in the 1980s, the Asian crisis of the late 1990s and the American-born Global Financial crisis of 2007-2008 brought financial turmoil created by sovereign debt into public prominence. The last three decades witnessed a significantnumber of financial crises, which mostly impacted emerging market economies but were also felt in highly developed economies. Whilst highly beneficial for some market players, in some cases speculative attacks have brought about considerable economic and social damage to several countries. The rapid expansion of international capital flows has been one of the dominant characteristics of globalization. The world urgently needs a mechanism to more effectively manage the financial crises that develop when debtor countries are unable to repay their international debts.
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