April 8, 2022
Ugo Panizza, The Graduate Institute Geneva and Centre for Economic Policy Research
There’s something happening here
What it is ain’t exactly clear
(Buffalo Springfield, 1967)
Public debt is at historically high levels in both advanced and emerging economies (Figure 1); there is a war in Europe; the pandemic is not over; the U.S. Federal Reserve increased its policy rate for the first time in more than three years (and expects to hike rates nine more times over the next 15 months); and the European Central Bank is moving towards a more hawkish stance.
The bond and equity markets do not seem to be excessively worried. I hope that they are right. But what if they are not? What if in the next few months we observed a turn of sentiments that leads to tighter financial conditions and to a wave of debt crises?
Is the international system ready for such an occurrence?
Figure 1: Debt-to-GDP ratios across the World
This figure plots the evolution of the median debt-to-GDP ratio (the solid black line) and its interquartile range (the dashed lines plot the top and bottom 25th percentile). Country classifications by income follow 2021 assignments by the World Bank; Ukraine and Russia are excluded from the sample beginning in year 2021.
The median spread for bonds issued by advanced economies is around 60 basis points, about the same level as the peak in March 2020 after the explosion of the COVID-19 pandemic (Figure 2). However, debt levels are now much higher. Median spreads in emerging and developing economies (excluding Russia, Belarus, and Ukraine) are 250 basis points lower than their March 2020 peaks.
Consider the case of Italy. In 2004, debt was 105% of GDP, and interest payments amounted to 4.5% of GDP; in 2012, debt crept to 125% of GDP, and interest payments were 5% of GDP. At the peak of the European debt crisis in late 2011, the Italian spread peaked at over 560 basis points (the yield was above 7%), and Italy’s public debt was just shy of 120% of GDP. Would anyone have believed that, in 2020, the Italian debt-to-GDP ratio would reach 156% of GDP with interest payments falling to 3% and that the country would borrow at a spread of 160 basis points over German bunds? (And this is after the recent increase.)
Low interest payments have been driven by two factors: (i) a European risk-free rate (that on German bunds) that is basically zero or negative and (ii) low sovereign bond spreads.
Spreads in Europe are low thanks to Mario Draghi’s “Whatever it takes” speech of July 26, 2012 and recent massive bond-buying efforts by the European Central Bank (ECB). However, Draghi’s speech was effective and the ECB’s interventions were not inflationary because the ECB is credible and inflationary expectations are well-anchored. Things would be different if the ECB (and other central banks in advanced economies) were to lose their credibility capital. But can the ECB keep its credibility capital without jacking up its rates and wreak havoc in high debt European countries?
Figure 2: Median Spreads in Advanced and Emerging Economies
This figure plots median spreads for U.S. dollar-denominated or euro-denominated bonds issued by advanced and emerging economies. Country classifications by income follow 2021 assignments by the World Bank; Ukraine and Russia are excluded from the sample beginning in year 2021.
Low interest rates in advanced economies (especially in the U.S.) have traditionally played an important role in determining capital flows to emerging markets. A sharp increase in interest rates in advanced economies could have disastrous spillover on borrowing costs in emerging markets. It could be the 1980s all over again, with higher leverage. But while spreads have increased, so far, markets do not appear to be pricing a looming disaster.
Looking at the share of countries that have lost market access provides another way to see that this is the case. Before the pandemic, fewer than 10% of emerging and developing economies that issued bonds in the international capital market could be deemed to have ‘no access’ to that market. The pandemic brought this share to 40% (nearly 30 countries, see Figure 3), but most countries regained access fairly rapidly, bringing the share of countries with no access back to 12-15% by November. Recent events have led to a small increase in the share of countries with no market access, but this share remains well below 20%.
Figure 3: Countries without market access
This figure plots the share (black line) and absolute number (gray line) of emerging and developing countries which do not have market access (“loss of market access” is defined for a country as having a sovereign spread above 750 basis points) at any given point in time. Country classifications by income follow 2021 assignments by the World Bank; Ukraine and Russia are excluded from the sample beginning in year 2021.
All in all, markets seem confident that central banks can control inflation without another Volker shock and that the war in Ukraine will not have long lasting effects on debt sustainability.
As my co-authors and I have previously proposed, a mechanism to implement a debt standstill would free significant resources, while also giving private creditors incentives to participate. While this proposal has built-in incentives for creditors, sticks are also necessary to avoid holdout problems and a rush to the courthouse.
To address this, we have put forward the notion of “legal air cover,” which aims at temporarily protecting countries against lawsuits during the restructuring periods. My co-authors and I focus on two options (described below) which can be put in place quickly, without the need for lengthy legislative wrangling or contract-by-contract and country-by-country negotiations. The air cover they provide may facilitate negotiations with creditors and buy time for conducting debt sustainability analyses, without the fear of a rush to the courthouse. In this sense, the proposed solutions can be useful to deal with both liquidity and solvency crises in a world that still lacks a statutory mechanism for dealing with sovereign defaults.
The first option is a UN Security Council Immunity Shield similar to that used to restructure the Iraqi debt accumulated by Saddam Hussein. The second option is an executive order by the U.S. President and a similar legislative action by the U.K. parliament (most international debt is issued under either New York law or English law).
A key issue is that these options involve a degree of ex-post intervention in debt contracts. Under normal circumstances, retroactive modifications of contract diminish the value of contractual commitments. Ex-post interference with contract terms can, however, be optimal in exceptional circumstances where the parties themselves—had they been able to negotiate a contract provision ex ante—would have wanted modifications to the contract.
The most important recent ex-post contract modification in sovereign debt is the Greek government’s decision to retroactively insert collective action clauses in all of its local-law-governed sovereign bonds in March 2012. Multiple challenges were brought against the Greek sovereign across a range of international fora with expropriation-type claims being made in each case. In all of these challenges, the courts sided with Greece.
Several observers suggested at the time that this “Greek Retrofit” would reduce faith in the value of contracts across the European Union and, therefore, increase the costs of borrowing for sovereigns in the European periphery. We analyzed the validity of these claims by conducting a series of event studies aimed at testing whether the court decisions mentioned above had an effect on the borrowing costs of Ireland, Italy, Portugal, and Spain. We found no evidence of negative spillovers leading to a systematic increase in borrowing costs for other vulnerable European sovereigns as a result of the various tribunals upholding the Greek ex post modification of contract terms. This result supports the idea that, when justified by exceptional events, ex-post contract modifications do not necessarily have negative repercussions.
Maybe markets are right and we should not be too worried, but it would be good to be ready in case they are wrong.
 The Graduate Institute Geneva and CEPR. This piece draws from Ugo Panizza, “Debt Risks in Advanced Economies,” in “Fiscal Sustainability in the Post-COVID-19 Era,” IEB Report (April 2021), and Patrick Bolton, Mitu Gulati, and Ugo Panizza, “Policies for Managing a Wave of Sovereign Debt Crises,” T20 Policy Brief (Sept. 2021). BACK TO POST
 See Guillermo Calvo, Leonardo Leiderman and Carmen M. Reinhart, “Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors,” IMF Staff Papers Palgrave Macmillan 40(1) (March 1993): 108–151, https://ideas.repec.org/a/pal/imfstp/v40y1993i1p108-151.html. BACK TO POST
 In this context “loss of access” is defined as having a sovereign spread above 750 basis points. BACK TO POST
 Patrick Bolton, et al., “Born Out of Necessity: A Debt Standstill for COVID-19,” CEPR Policy Insight no. 103 (2020), https://cepr.org/active/publications/policy_insights/viewpi.php?pino=103. BACK TO POST
 Patrick Bolton, Mitu Gulati, and Ugo Panizza, “Legal Air Cover,” Journal of Financial Regulation 7, no. 2 (Oct. 2021): 189-216, https://academic.oup.com/jfr/article/7/2/189/6263494?login=true. BACK TO POST
 Among the attractive aspects of the UN Security Council resolution is that it creates worldwide immunity for the assets of the sovereigns in peril and it does so with speed. Of course, this requires agreement from the leadership of countries that are in the Security Council; something that is not plausible in the current context. BACK TO POST
 Bolton et al., “Born Out of Necessity,” provides details and examples. BACK TO POST
 Ibid. BACK TO POST
Return to Debt Architecture Architecture, Suspended prompt.