April 12, 2022
Layna Mosley, Princeton University & Peter Rosendorff, NYU
The challenges related to sovereign debt burdens and restructurings are inherently political. While much attention has focused on the international dynamics of default and restructuring, the conversation also must confront politics within indebted countries. Governments’ incentives to impose austerity, to seek restructuring and to continue paying their debts vary as a function of their political survival calculus. The willingness to pay and the propensity to restructure are ultimately about the domestic political economy of sovereign debt.
With global public debt at an all-time high, dozens of countries seem to have spent a year or more on the verge of a debt crisis; at least eight have defaulted or launched restructurings, and others are about to follow suit. In 2020, 51 countries (including 44 emerging economies) saw their sovereign credit ratings downgraded. Debt servicing costs are on the rise (many governments took on additional debt in 2020 and 2021) and rising energy and food prices, a continuing pandemic and monetary tightening in the U.S. and Europe suggest even higher fiscal and debt-servicing burdens.
How ought we to understand the political economy of debt distress and restructuring under these circumstances? Creditor coordination can pose a significant problem: according to the most recent World Development Report, a government seeking debt restructuring averages 20 distinct creditors. An increasingly diverse range of creditors means even greater variation in creditors’ degrees of exposure; in motives (profit, strategic influence); in time horizons; in willingness to reveal information about their lending activity; and in capacity to overcome collective action problems.
The diversity of creditor interests contributes to widely-acknowledged challenges, as creditors compete to be first in line, and restructuring negotiations stall. The absence of a treaty-based sovereign debt restructuring mechanism at the global level further complicates these challenges. Inter-creditor fights hindered the effectiveness of the Debt Service Suspension Initiative (DSSI), despite initial enthusiasm for its prospects during the first stage of the pandemic. A similar fate threatens the G-20’s Common Framework.
But, while ramping up cooperation internationally is necessary for addressing debt-related challenges, it is not sufficient in the current environment. We must also look to domestic politics. The political economy of sovereign debt is a two-level game: at the international level, governments bargain with creditors (and creditors bargain with one another). Governments may attempt to convince creditors to accept larger haircuts, while creditors may pressure governments to commit to structural adjustment as a condition of debt relief or the extension of new financing.
At the domestic level, all governments, democratic or not, left or right, facing debt crises or not, worry about their political survival. Will a default reduce the political support from domestic holders of debt? To what extent will the austerity required by an agreement with the International Monetary Fund (IMF) — often a prerequisite for a restructuring — harm constituents with strong domestic political voices? How might default affect the access of politically well-connected local firms to foreign credit? How does the proximity of national elections complicate decisions regarding whether to pursue or delay economic reform? Each of these questions reminds us that even an external debt restructuring is, fundamentally, a domestic political challenge. The choice to repay, restructure, or default has distributional consequences. Some groups bear a greater burden, while others reap more benefits. All governments weigh these costs and benefits, which vary with domestic institutional structures as well as with the electoral calendar.
The role of domestic politics in the realm of sovereign debt is perhaps old news: default risk has long been conceptualized as consisting of the ability and the willingness to repay. Ability may be more easily assessed, in terms of macroeconomic conditions. Willingness, however, can be more difficult to gauge: under what conditions does a government choose to honor its commitments to creditors? When might it have incentives — even, perhaps, when economic times are good — to defect from those commitments?
Our current academic and policy conversations about debt must account for variation in governments’ willingness to pay, and for the shifts in willingness which stem from changing domestic political conditions. Otherwise, the best-designed international initiatives may falter. In doing so, there are many ways of conceptualizing the domestic interests related to restructuring, austerity and default. One might consider who a government’s creditors are: does it owe money to domestic investors and financial institutions, to foreign investors and financial institutions, or to some combination of the two?
Classic accounts of the “democratic advantage” — in which government commitments to debt repayment are assumed to be greater in democracies rather than autocracies — rest on the presence of bondholders within the domestic polity. Default is costly for governments because of the political voice of creditors; this voice restrains the sovereign’s fiscal policy and facilitates debt repayment. (The composition of the investor base — and the decision to issue debt domestically versus internationally, as well as decisions across types of external creditors — also have domestic political roots.)
In the contemporary period, the presence of domestic creditors may mean imposing losses (in the form of a haircut) on domestic constituents, which might include private banks, institutional investors or retail investors. The magnitude of any restructuring is likely to be reduced when those holding financial assets are members of the political elite. In such situations, it might be possible for a government to default on foreign but not on domestic creditors: minimal contractual and institutional linkages between external and domestic debt, which typically do not cross-default to one another. (For data on when governments choose to restructure foreign-law but not domestic-law debt, or vice versa, see this recent IMF analysis.)
But even if a government defaults selectively, domestic groups are nonetheless exposed to the indirect costs of restructuring, particularly where it affects access to foreign capital. That is, to the extent that restructuring (or default) damages a country’s capacity for future borrowing, it also might damage the capacity of domestic banks, non-bank firms and individual households to access foreign capital. If these groups have a strong political voice — for instance, if the banking sector is politically well-connected or if mass publics hold significant debts and worry about rising interest rates — then we can expect governments to focus on maintaining (rather than restructuring) their external obligations.
Alternatively, governments may favor those who would be harmed by continued debt repayment and who would benefit from a deeper restructuring. To the extent that debt burdens reduce governments’ capacity for other types of spending — for instance, on food subsidies or income supports — then we might expect left-leaning parties, or those with strong working-class support bases, to insist on larger investor haircuts, or to quit servicing their debts. Such governments also might worry that negotiating an agreement with the IMF would further damage their domestic status, especially when it might require them to remove subsidies for food and fuel.
Considerations of political survival apply to all regime types and across electoral systems. The exact dynamics of political survival, however, will vary with political institutions. For instance, dictatorships may worry about preventing urban riots, while democracies focus on maintaining the electoral support of rural voters. Or, in democratic countries with candidate-centered electoral systems, internationally-oriented economic groups may lobby more effectively (for smaller restructurings) than mass publics (who would prefer larger investor haircuts).
Finally, the electoral cycle affects a government’s willingness to negotiate with its creditors and with international financial institutions. To the extent that a government faces a looming election, it may well attempt to hold on, avoiding imposing an adjustment burden on any domestic group until after the votes are counted. This practice — which also can occur whenever there is uncertainty about which domestic groups will bear the costs of adjustment — further complicates international negotiations over debt. It also might invite post-election speculative attacks, as investors also are aware of the electorally-induced desire to delay stabilization.
The complications introduced by domestic politics are a persistent feature of debt restructurings and crises. The international community might consider how these could be mitigated — for instance, how the burden of austerity could be reduced, but in ways that do not leave creditors unwilling to accept restructuring deals. High levels of austerity not only can have deleterious economic consequences; they also can leave governments unwilling to accept the IMF deals that typically are a precondition for negotiating with creditors. Perhaps in recognition of these domestic political concerns, the IMF sometimes has made concessions in its program design.
And more generally, those who analyze the dynamics of restructurings should appreciate that the domestic politics surrounding restructurings often generates a status quo bias. If governments perceive any action related to debt as detrimental to their political survival, they will delay. Delay often leads to deepening crises; and even with better international procedures for creditor coordination and debt restructuring, we may continue to observe slow-motion fiscal collapses. Sri Lanka’s current situation may illustrate these dynamics: the country’s economic crisis has meant shortages, price hikes and power cuts, leading to mass protests. Demonstrators have called on President Rajapaksa to resign. The central bank governor and (newest) finance minister resigned in early April, and forty-one legislators resigned from Rajapaksa’s party. Yet, thus far, Rajapaksa has been unwilling to resign (not surprisingly) or to enter into negotiations with the IMF (although this seems on the horizon). Rather, he appears to hold out hope of a bilateral bailout, or some other rescue, even as his political fortunes deteriorate.
Understanding of the political constraints faced by leaders is essential for debt crisis response. The most carefully balanced debt-restructuring package is a non-starter if the burdens of adjustment fall on the politically influential, or fail to take account of the electoral calendar, or ignore the game being played between foreign and domestic holders of the debt. Domestic politics is the source of the “willingness” to repay; forget this at the peril of any international debt resolution system.
Return to Debt Architecture Architecture, Suspended prompt.