Re-Reintroducing Sovereign Bankruptcy

In early October 2008, I wrote about the concept of sovereign bankruptcy in the context of Iceland’s banking crisis, and that we should get used to the idea of a country declaring bankruptcy. The following weeks saw Iceland’s crisis result in the collapse of its currency and stock market, and nationalization of banks.

A year later, media outlets such as The Economist and WSJ are buzzing about sovereign bankruptcy once again, as the subsidiary of the Dubai emirate Dubai World is extending its payment deadlines. The ruling family of Dubai has sworn off ultimate liability for the debts, claiming that they are the shareholders and not jointly and severally liable, but this has nonetheless ignited talk worldwide about the issue of sovereign bankruptcy.

Of course, the United Arab Emirates have plenty of money — it’s Dubai that is facing liquidity problems. And I think the problem is more an issue of “subprime meltown, part 2″ than defaulting on sovereign debt, with the amounts at a paltry 10% of Lehman’s obligations when it filed for Chapter 11 last year. Dubai also has a number of cushions unavailable to many debtors over the past few years as the “Too big to fail” institution of the Middle East. The emirate of Dubai may feel compelled to bail out Dubai World; Abu Dhabi, as the oil-rich capital of the UAE, may feel compelled to bail out Dubai; and other interested parties in the region may feel compelled to further help Dubai, such as the Saudis, if things get even worse. (There are also some who think that Abu Dhabi’s mass purchase of Dubai bonds is to limit possible Saudi influence over Dubai.)

But “too big to fail” is supposed to apply to multinational institutions, not sovereign states — modern states in today’s world are “too big to even contemplate failure” — until now. Commentators are now worrying that Iceland and Dubai may only be the beginning, and the New York Times has a graph that shows the scope of debts by at-risk countries.

sovereign debt

On top of this, there is the risk that developed, industrialized countries such as Portugal, Spain, Italy, or even Japan — which now has public debt in excess of 200% of it’s GDP with poor future prospects for growth — could default on debt in the near future. All of this is bringing us into a world that makes the future impossible to forsee with any accuracy, and sovereign bankruptcy could bring us into unknown territory far beyond what Lehman’s collapse showed us.

About Curzon

Lord George Nathaniel Curzon (1859 - 1925) entered the British House of Commons as a Conservative MP in 1886, where he served as undersecretary of India and Foreign Affairs. He was appointed Viceroy of India at the turn of the 20th century where he delineated the North West Frontier Province, ordered a military expedition to Tibet, and unsuccessfully tried to partition the province of Bengal during his six-year tenure. Curzon served as Leader of the House of Lords in Prime Minister Lloyd George's War Cabinet and became Foreign Secretary in January 1919, where his most famous act was the drawing of the Curzon Line between a new Polish state and Russia. His publications include Russia in Central Asia (1889) and Persia and the Persian Question (1892). In real life, "Curzon" is a US citizen from the East Coast who has been a financial analyst, freelance translator, and university professor; he is currently on assignment in Tokyo.
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17 Responses to Re-Reintroducing Sovereign Bankruptcy

  1. tdaxp says:

    Good post.

    One major change of modern sovereign bankruptcy and corporate bankruptcy, however, is that in corporate bankruptcy creditors can petition a higher authority to be handed control of the company. Obviously, Dubai won’t be run by HSBC any time soon…

  2. Brent says:

    Of the countries on your list, Greece has the least wiggle room. They are tied to a currency (Euro) that they cannot devalue, and therefore, there is limited availability for them to avoid a complete default, as Germany will not devalue just to save Greece.

  3. Curzon says:

    Thanks for both the comments, both are very true.

    TDAXP, in the current Dubai case, creditors are looking at seizing certain assets that were put up as collateral, so the current Dubai debacle truly is an issue with commercial, and not sovereign, debt.

    Brent, do you know if there is a set procedure for a country to leave the EU? Is that stated anywhere in the constitutional documents and agreements that established the Euro currency?

  4. Brent says:

    Curzon,

    I honestly don’t know how Greece could exit the Euro. I presume they retain that ability, both legally and in reality. I can’t imagine Germany et al. invading Greece to force it to stay in the currency union. Unlike in the US, the states in the EU still retain substantial freedom of action. For now, at least.

    Greece probably does not want to exit the Euro, as, until recently, it benefited from much lower interest rates on its government debt.

    However, thinking about this further, perhaps Germany et al. actually would intervene to save Greece, IF Greece threatened to exit the Euro as that would marginally weaken the currency and possibly set off a domino effect of others leaving (earlier this year an Irish central bank economist said Ireland should consider leaving the Euro). It would probably boil down to how much money was required, and how much control they would get over Greek finances going forward (as otherwise Greece would just run up debts again).

    This may also be of interest to you on the subject:

    http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/6630117/Greece-tests-the-limit-of-sovereign-debt-as-it-grinds-towards-slump.html

  5. IJ says:

    Unless the rules of the global economy change, it is likely that many countries in the ‘developed’ world will declare sovereign bankruptcy. The United States will be the largest one and most systemic to the global economy.

    But few are keen to change the rules. The US has immense influence here. The argument still holds sway in Washington that yes the US might have bigger and bigger trade deficits, big fiscal deficits and colossal borrowings from the rest of the world; but on the plus side the US companies that have offshored and are selling to America are doing well. Corporate profits matter; residents of the US don’t; Schumpeter warned against such creative destruction.

  6. Curzon says:

    Brent, I think you’re right that the biggere EU economies might do a bailout, but I don’t think it’s that harmful to the interests of the EU as a whole, nor to the major powers using the Euro such as Germany and France, if one secondary country drops the Euro so that it can hyper-inflate its way out of debt, and then eventually return to using the Euro. Although in practice, the later does seem like the uncertainty surrounding the process, and the panic that would ensue during the process, may make it a nightmare.

    IJ, that sounds outlandish, and I don’t see how it’s true. Hyperinflation seems far, far more likely for most developed countries than sovereign bankruptcy.

    I frankly think that we need a major restructuring of government in the industrialized world. So much dynamism comes in the private sector in the wake of corporate restructurings. Governments now are reeling at the sudden drop in revenue following the financial crisis. This type of situation could prompt bankrtupcy, and a restructuring, in the case of a company. A government should do the same — aggressively dump its underperforming divisions, seek to reduce inefficiency, and streamline in the same way a corporation is restructured. That would go a long way to improving the balance sheets of a lot of countries.

  7. M-Bone says:

    Some interesting buzz lately about Japan’s debt -
    http://online.wsj.com/article/SB10001424052748704779704574555132306518464.html

    So it seems as though the 200% figure includes not only national, but also provincial and municipal debt and that about half of Japan’s debt consists of money that different arms of the Japanese government owe each other. A net interest rate on that debt of 1.3% also gives Japan way more wiggle room than the 2.6% OECD average that Katz cites. Until I saw Katz’ article, I had no idea that this was the case. Sure paints a different picture.

  8. IJ says:

    Outlandish?

    Anyway, I recommend the Warwick Commission’s recent report on the reform of international finance. The chairman wrote an introduction in the Financial Times.

    One of the features that singles out the Warwick Commission on International Financial Reform. . . is that while other expert groups tiptoe around it, we have been able to point to the true source of the worst financial crisis since the 1930s: regulatory capture and boomtime politics.

  9. Master Cook says:

    So when is the US going to default? That is what everyone wants to know. Some of the numbers here look really scary.

    What advantages do the other EU countries get from Greece being part of the EU? The Economist campaigned a while back to kick them out. I can’t think of any real reason to keep them in except that geographically, Greece is part of the European continent.

  10. kurt9 says:

    sovereign bankruptcy will provide the incentives for the development of private currencies. A competitive basket of private currencies will help mitigate the pernicious effects of sovereign bankruptcy, if they should occur.

  11. Thomas says:

    Twice GDP is a high, but not unheard of and not unmanageable amount of debt. Italy ran such debt a decade ago and did not collapse economically.

    More important, though, is that debt is simply another financial instrument that can be bent, structured and manipulated as needed.

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  13. TDL says:

    An interesting issue to pay attention to is how the holders of “Islamic bonds” will be treated. Since these bonds are structured by using Special Purpose Vehicles where the underlying asset is sold to the SPV and then the “investors” (lenders in reality) buy shares in the SPV. Not having seen a prospectus or term sheet, I am not sure how these vehicles would hold up in restructuring negotiations or in the Dubai courts (who are objective, right?!) Also, these vehicles have never been tested in any court.

    Thomas,
    I would make the argument that there is an upper threshold that acts as a breaking point when it comes to debt. Eventually, revenue streams will have to be sufficient to maintain the obligations that come along with any type of debt. The more debt and the more complex that debt becomes, the less wiggle room the underlying asset has (I am paraphrasing David Merkel at the Aleph Blog.) Debt forces institutions to become more and more rigid, just when they need to become nimble.

    Also, as far as a U.S. default, here is a scenario: Inflating @ 10% to 15% (like Dan [TDAXP] mentioned on his blog a while back & Curzon hints at above), while a populist president opts to redeem Treasuries from banks @ ~$.25 on the dollar & ~$.50 on the dollar from foreign central banks leaving pension funds, individual investors, trusts, etc. untouched.

    Regards,
    TDL

  14. Roy Berman says:

    “I can’t think of any real reason to keep them in except that geographically, Greece is part of the European continent.”
    I think that, frankly, it comes down to the fact that Greece is historically the source for much of Europe’s continent-wide culture, and insofar as the EU represents a cultural region and not merely a a geographic one, Greece’s presence is required for fairly important symbolic reasons. Of course that still doesn’t remotely apply to their use of the Euro.

  15. Oliver says:

    “I can’t imagine Germany et al. invading Greece to force it to stay in the currency union.”

    The problem is what does the rest of the Eurozone do if Greece starts printing Euros without the ECB’s permission.

    It is unlikely that a fully developed state would simply default. All of them have a running deficit they need to finance. Therefore they’d rather print money, or technically, have the central bank buy bonds.

  16. IJ says:

    Fiat currency debts?

    Some nations have already made escape plans. Holdings of gold may be more important come the financial apocalypse.

    The top 20 holdings are reported to be:
    1. USA [8133 tonnes]; 2. Germany [3408t]; 3. IMF [3217t]; 4. Italy [2451t]; 5. France [2445t]; 6. China [1054t]; 7. Switzerland [1040t]; 8. Japan [765t]; 9. Netherlands [613t]; 10. Russia [568t]; 11. ECB [501t]; 12. Taiwan [424t]; 13. Portugal [382t]; 14. India [358t]; 15. Venezuela [356t]; 16. UK [310t]; 17. Lebanon [287t]; 18. Spain [282t]; 19. Austria [280t]; 20. Belgium [228t]

  17. Brent says:

    Oliver said “The problem is what does the rest of the Eurozone do if Greece starts printing Euros without the ECB’s permission.”

    This is interesting. I was tempted to reply that Greece is trapped by its deficits, in that it needs money to pay for social programs and wages to keep its population from rioting (which some have done upon merely the threat of cuts). However, printing money solves this problem.

    Clearly, the Greeks would have the technical ability to print Euros that would be indistinguishable from those printed “legitimately” (as I understand that Iran and North Korea have been known to print conterfeit dollars, and if they can do it, so could Greece).

    Presumably, the rest of the EU would respond with economic sanctions. As they naturally avoid military action and the US would likely not be willing to intervene. How would Turkey react? Would Russia and China comply with the sanctions?

    But, fundamentally, what keeps countries from rampant counterfeiting of another currency, other than fear of retaliation? Presumably, there is some restraint on this that I’m missing, otherwise why wouldn’t Greece do exactly what Oliver suggests?