September 07, 2022
Juan Flores Zendejas, University of Geneva
Changes in borrowing patterns by many middle-income countries reflect ongoing changes in the economic and geopolitical context. Market volatility and investors’ risk aversion in response to events such as the COVID-19 pandemic and the war in Ukraine threaten to exacerbate lending bifurcation, where the bond markets are accessible to some countries but closed to others. Governments that lost bond market access in the face of growing financing needs look for alternative funding sources, amplifying and accelerating diversification. As creditors continue to grow more heterogeneous, debt default management and creditor coordination are likely to become major challenges to global economic governance. For as long as bond markets remain dominant in sovereign debt, solutions could include contractual provisions specifying relative priority of repayment among creditors or the conditions under which a restructuring would take place. In certain cases, the IMF and governments from creditor countries have tried to intervene proactively to avert a sovereign default or at least minimize damage to the stability of the international financial system.
Nonetheless, the dearth of coordination devices leads to unnecessary costs to defaulting countries and negative spillover effects for others. Up to now, there has been a lot of criticism of how the prevailing financial non-system has placed the burden of default on borrowers.[i] Many such critiques have attributed the economic and social costs of default to the fact that a government’s decision to default often arrives “too little” and “too late”, and to the failure of attempts to institutionalize a debt resolution mechanism. The growing share of creditors from non-market and hybrid economies such as China may lead us to ask whether we are witnessing the end of the “hegemony of finance,” one in which private investors and financial intermediaries occupy a prominent role in world politics and in the global economy. In such regimes, the rules and procedures governing sovereign debt were defined and implemented by a strong financial sector and enforced, if necessary, by a political hegemon. The debt form has enabled creditors to exert tremendous power over debtor states.[ii] The implementation of economic policies through conditional lending is the most readily accessible illustration of this power dynamic.
As U.S. political hegemony is increasingly contested, we might expect changes in the hegemony of finance. In contrast to previous transition periods with a declining political hegemon, such as Great Britain early in the 20th century, the heterogeneity of creditors today poses a new challenge for handling sovereign defaults in the future. This challenge stems from the fact that some of the new lenders do not necessarily share the interests and objectives behind established borrowing and crisis management practices. Competition among creditors could improve the terms and conditions under which governments borrow, but it could also trigger unnecessary and unforeseen consequences, complicating or mitigating crisis management.
What are the historical parallels to periods in which a hegemon no longer dictates and implements the rules and practices that dominate the economic system? First, not all periods with hegemonic regimes have led to the same levels of influence over debtor countries. During the 19th century, as Britain emerged as a hegemonic power, the country was the main capital exporter, and foreign governments looked to London for external funds. British bondholders designed devices to gain bargaining power when negotiating with defaulting governments. These devices included bondholder associations such as the Corporation of Foreign Bondholders (CFB). The CFB could exert influence over stock market regulations and exclude a defaulting government from accessing the London capital market.[iii] This body could also lobby the British government to adopt a more proactive role in defending investors’ interests, including the possibility of resort to gunboats. However, the British government generally refrained from intervening on bondholders’ behalf unless such an intervention coincided with its own political aims.[iv] In the context of colonial expansion—when territorial ambitions entered into the equation—a debt dispute could lead to an erosion of a borrower’s sovereignty and to the establishment of colonial regimes. This was the case after Egypt’s default in 1876, with colonial status established in 1882.
As other national associations of bondholders were formed in the Netherlands, Belgium, and France, following their British counterparts, they coordinated among themselves and managed to exclude defaulting governments from access to the international capital markets beyond London.[v] This coordination was facilitated by the fact that bond markets were strongly integrated: European underwriting banks, later joined by U.S. banks, placed the same bonds in different markets. Against the backdrop of coordination, British underwriting banks could also influence the borrowers’ economic and foreign policies from time to time.[vi] By the end of the 19th century, there was a certain uniformity in the kinds of economic policies demanded to defaulting countries. These included fiscal, monetary, and commercial policies: balanced public finances, adherence to the gold standard, and trade openness, among others. Overall, this framework promoted foreign investment (particularly British, but increasingly also French and German) and international trade.
There were limits to British hegemony. In particular, Great Britain did not control policy in Asian and African countries under the rule of other major colonial powers. In countries where inter-imperialist rivalry was at stake and lenders were obliged to find common solutions to a debt default, British investors and the British government coordinated with other bondholder associations and with governments from other capital exporting countries. According to Şevket Pamuk, British hegemony began to give way to more inter-imperialist rivalry by the end of the 19th century, which made it impossible to have any hegemonic power colonize certain territories.[vii] Default by the Ottoman Empire led to the formation of the Ottoman Debt Council of 1881, which managed and collected part of the revenues of the country for bondholders from half a dozen countries.[viii] The council was formed by representatives from British, French, Dutch, German, Italian, and Austro-Hungarian bondholders. The literature still debates the economic effects of the debt council, which lasted until 1928. However, there is no doubt that the political erosion in the Ottoman Empire’s fiscal sovereignty was tremendous.[ix]
The transition from British to U.S. creditor hegemony during the interwar period destabilized the global economic system.[x] After the transition, the institutional structure for sovereign borrowing, including debt dispute resolution, stood in sharp contrast to its 19th century predecessor. One difference was the shift from pound sterling to the U.S. dollar as the dominant currency for sovereign debt; this in turn brought more changes in contractual and institutional practices. For example, most sterling loans had specific public revenue pledges, while dollar loans did not. Such differences triggered debates among bondholders regarding their legal effect, and whether secured loans enjoyed repayment priority. As expected, U.S. interests prevailed, putting both secured and unsecured loans on the same footing.[xi]
Perhaps the most important contrast between the pre-World War I and the post-World War II regimes was the attitude of the U.S. government towards defaulting governments and American bondholders. The U.S. Foreign Bondholder Protective Council (FBPC), whose formation was promoted by the U.S. government itself, initially favored short-term agreements, but was obliged under U.S. governmental pressure to accept long-term agreements with deep haircuts. Deep haircuts were a feature of the German Debt Agreement of 1953, recognizing the need to foster Germany’s economic recovery among the relevant political and economic factors. Loans from the recently established U.S. Export-Import Bank as well as multilateral organizations such as the IMF and the World Bank provided incentives for governments to settle their disputes with bondholders. Such public financing encouraged the resumption of bilateral trade with the United States, but also put borrowers in a better bargaining position. The position of the FBPC, largely conditioned by the preferences of the U.S. government, set the tone for other bondholder associations: in practice, their recovery was now limited to obtaining the same terms as their U.S. counterpart. The new U.S. hegemon dictated the terms and patterns of new lending, including the turn away from private markets and towards official (public) lending. With the dominant public lenders closely aligned, coordination ceased to be a relevant issue.
Today’s transitional conditions differ in a least three ways from the earlier pattern. First is the speed with which this transition is taking place. The decline of Britain’s hegemonic regime took decades, even as it accelerated during World War I. While Britain remained an important trading partner for most borrowing countries, the United States emerged as the main creditor after World War II. Nevertheless, the rules and norms of foreign borrowing during the interwar were not sharply different from practices during the 19th century. Only after World War II did the consolidation of U.S. hegemony require it to prioritize foreign policy interests over the need to minimize investors’ losses. Today, China has emerged as a major trading partner for many countries, and its role as creditor country has also accelerated in the last two decades. However, the identity and variety of Chinese creditors raise questions about their alignment with China’s foreign policy objectives and the consequent ways in which they will manage sovereign defaults.
Another difference is that, during the transition period of the 1920s, U.S. and British underwriting banks coordinated ex ante in their lending before they had to restructure. Investment banks in New York and London could jointly decide where, when, and how to issue a new loan. This collaboration further involved the exchange of information on borrowing governments if deemed necessary.[xii] Lender coordination was not as complex as it would have been if it were a segmented market. In contrast, new and established creditors today face a bigger restructuring challenge because they pursued independent lending practices leading up to the crisis. The lack of publicly available information on lending terms exacerbates the challenge.
The third and final difference between old and new hegemonic transitions concerns the role of politics in the resolution of defaults. Here the picture is murkier, with outcomes unknown or yet to materialize. As mentioned above, for the 19th and first half of the 20th century, territorial ambitions linked debt, colonial expansion, and imperial rivalries. The French invasion of Mexico in 1862 and the British, German, and Italian blockade of Venezuela in 1902 were triggered by debt defaults and generated further tensions between the United States and its European counterparts. We might wish that such territorial ambitions and competition for spheres of influence were no longer central to today’s debt politics. In an integrated global economy, politics might well prioritize economic recovery, much as it did in the post-World War II period. US and Chinese lenders may mutually benefit from favoring the development of defaulting countries.
[i] José Antonio Ocampo and World Institute for Development Economics Research, Resetting the international monetary (non)system (Oxford University Press, 2017), 177.
[ii] Pierre Penet and Juan Flores Zendejas, eds., Sovereign Debt Diplomacies: Rethinking Sovereign Debt from Colonial Empires to Hegemony (Oxford, New York: Oxford University Press, 2021), 27.
[iii] Marc Flandreau, “Sovereign States, Bondholders Committees, and the London Stock Exchange in the Nineteenth Century (1827–68): New Facts and Old Fictions,” Oxford Review of Economic Policy 29, no. 4 (2013): 668–96.
[iv] Michael Waibel, Sovereign Defaults before International Courts and Tribunals, Cambridge Studies in International and Comparative Law 81 (Cambridge: Cambridge University Press, 2011), 23.
[v] Juan Flores Zendejas, Pierre Pénet, and Christian Suter, “The Revenge of Defaulters: Sovereign Defaults and Interstate Negotiations in the Post-War Financial Order,” in Sovereign Debt Diplomacies. Rethinking Sovereign Debt from Colonial Empires to Hegemony, by Pierre Pénet and Juan Flores Zendejas (Oxford: Oxford University Press, 2021), 165–86.
[vi] Marc Flandreau and Juan H. Flores, “The Peaceful Conspiracy: Bond Markets and International Relations During the Pax Britannica,” International Organization 66, no. 02 (April 2012): 211–241.
[vii] Şevket Pamuk, “The Ottoman Empire in Comparative Perspective,” Review (Fernand Braudel Center) 11, no. 2 (1988): 127–49.
[viii] Edwin Montefiore Borchard, State Insolvency and Foreign Bondholders (New Haven: Yale Univ. Press, 1951).
[ix] Didac Queralt, Pawned States: State Building in the Era of International Finance (Princeton University Press, 2022).
[x] Charles Poor Kindleberger, The World in Depression, 1929-1939, History of the World Economy in the Twentieth Century Vol. 4 (London: Allen Lane The Penguin Press, 1973), 289.
[xi] Barry Eichengreen and Richard Portes, “Settling Defaults in the Era of Bond Finance,” The World Bank Economic Review 3, no. 2 (1989): 211; Juan Flores Zendejas, “Contesting the Preferred Creditor Status of the League of Nations, 1931–3†,” The Economic History Review 74, no. 4 (2021): 1062–86.
[xii] See, for instance, the case of JP Morgan and its British counterparts: Vincent P. Carosso and Rose C. Carosso, The Morgans: Private International Bankers, 1854-1913 (Harvard University Press, 1987), 589.
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