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Tuesday, January 24, 2012

Can sovereign states go bankrupt?

Bill Clinton would probably answer this question by saying "That depends on what you mean by bankrupt"; and he would be right!

Bankruptcy can be used as a description of economic reality or as a legal/technical term. If "bankruptcy" is used in a legal sense, it can only be meaningful where there are bankruptcy laws. Without bankruptcy laws, there cannot be a legal bankruptcy. This is why the economic reality of a bankruptcy of a sovereign state is quite different from the legal bankruptcy of a person or company (to my knowledge, there are no bankruptcy laws for sovereign states anywhere).

A sovereign borrower could best be compared to a private individual before bankruptcy laws for private individuals were implemented. The debt which a private individual incurred during his twenties remains with him until he dies (or until it is fully repaid, whichever came sooner). A sovereign state cannot really die (exceptions: revolutions where the new state repudiates the former state). Thus, the debt remains legally in place unless there is a consensual agreement between borrower & creditors to forgive some of the debt.

Repudiation of sovereign debt might be an exception to this. If a state passes a law stipulating that its debt will not be paid, that might work within its own jurisdiction (even though, with the EU, nationals of that state could probably sue successfully at the level of the EU). It definitely will not work outside its own jurisdiction. If the loan agreement stipulates that the loan is payable in Euros at a bank in, say, France, then that loan remains "unpaid" until there are Euros delivered to a bank account in France.

Argentina once pulled the trick (1980s) that they would repay USD debt in local currency equivalent at an Argentine bank account and, thus, consider the debt as repaid. Argentine courts agreed to this procedure. Foreign banks sued in foreign courts of law and obviously won the case there because, according to the loan agreements, the USD debt could only be considered as repaid if and when USD had been credited to a bank account in NYC.

What is the net result of this? Never-ending litigation until some consensual solution is reached.

There are always two aspects in connection with the repayment of debt: the borrower's ability to repay and the borrower's willingness to repay. A country is well-advised to observe the following rule of conduct:

As the objective ability to repay debt decreases, the displayed willingness to repay it must increase!

Since a sovereign state cannot legally go bankrupt (i. e. it cannot reduce its debt by going through bankruptcy proceedings), there is absolutely nothing to be gained by threatening not to pay debt. And the worst of all actions would be to repudiate sovereign debt because there is absolutely nothing to be gained from that, either! (Lenin allegedly once said that one of the greatest mistakes of his revolution was to have repudiated the debt of Tsarist Russia).

If a sovereign borrower gets into trouble, non-payment of its debt (default) will occur unless someone comes to help with new financing. Thus, something which will happen automatically does not need to be announced! Even less does it need to be threatened with because every thinking person already knows that it will happen.

If, on the eve of an unavoidable default, Greece were to announce that she will default the next day, nothing would be gained. If, instead, Greece announced that "we will work all night long to do everything possible to avoid default", a lot is gained. What is that "a lot"? It is the reputation that the willingness was there, albeit not the ability. If foreign countries argue that it is about time that Greece should declare herself insolvent, Greece should ignore that.

And what are the possible lessons for Greece?


1. Certainly, reinforce day-in and day-out the intention to fully honor all sovereign commitments. If not on time, then because of the lacking ability to do so but never because of the lacking willingness.

2. Refuse any offer for a debt forgiveness (haircut). A debt forgiveness with a sovereign state doesn't make sense from the creditors' standpoint, as explained above. It makes even less sense from the borrower's standpoint.

3. Work towards a rescheduling with existing creditors. Refuse a transfer of debt from private creditors to tax payers. If concensus is that Greece has 150 BN EUR more debt than she can sustain, then the solution is not a haircut. The solution is to convert that portion of the debt into a long-term (or evergreen) bond which from today's standpoint might not have a chance of ever getting paid but which might be paid in the future (the creditworthiness of a country can change quite significantly within one or two decades). And that new bond must be purchased by existing creditors and not by tax payers!

4. The level of sovereign debt per se in not very relevant. What matters is the amount of cash interest which flows through the budget. If cash interest expense reaches "unbearable" levels, then interest rates need to be lowered and/or interest needs to be capitalized (i. e. payable later). The term "unbearable" is subject to interpretations. Today, Greece's interest expense amounts to about 12-13% of total expenditures. In 1996, it was twice as high (24%).

5. Most importantly, the Greek economy needs to be jump-started. There are economically bankrupt states and there are bankrupt economies. If the economy is strong, the state can get away literally with "murder". Germany is today not far from being a bankrupt state but her economy is very strong. Only if the Greek economy becomes strong does the Greek state have a chance to become strong, too!

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