GEST S 531
Sovereign Debts: a Historical
Perspective
Kim Oosterlinck ©
Sovereign debts
Many ways to define sovereign debts :
1. All debts issued by a sovereign state
2. Debts issued abroad by a sovereign state
3. Debt issued by developing countries (Eaton &
Fernandez, 1995)
Each definition puts the focus on a different aspect
Before the Eurozone debt crisis, the third definition
seemed to be the most appropriate, sovereign debt
defaults were only happening in third class countries with
dodgy finances…
Which leads us back to our classification issue…
(c) Kim Oosterlinck
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Sovereign debts
• Huge amounts at stake, many mentions in the press
• Developing Countries, foreign sovereign debts
estimated at 4,546 billion USD in 2008 (IMF, 2008)
• As bonds, more or less 370 billion USD (Roubini &
Setser, 2004a) out of 3 000 billion USD at the time
• Since 2008, many sovereign debt crises in Europe
(Greece, Portugal, Italy, Spain…)
• For Belgium mention of the debt in relation to a
potential country break-up and this on a regular basis
• When Saddam Hussein was overthrown discussion as
to whether the Iraqi people should repay the debt
(c) Kim Oosterlinck
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Lenders of various nature
• General public (bonds with our without
specific clauses (collective action, exchange
etc.))
• Interstate debts
• Bank debts
• International Financial Institutions
• Defaults handled in very different ways (Cf
Rogoff et Zettelmeyer (2002), and may lead
to moral hazard issues…
(c) Kim Oosterlinck
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Historically…
• For a long time most traded assets
• Sovereign debt market experienced a dramatic
evolution since 1870, with four major periods:
– Gold-standard (1870-1914) and1930s
(bearer bonds, many individuals)
– Bretton Woods (Interstate, Paris Club)
– Post Bretton Woods (Bank lending, London
Club)
– Post Brady (come back of the bondholders)
(c) Kim Oosterlinck
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Sovereign debts
• Unique financial instrument. In fact sovereign debts
are almost an example of “oxymoron”. How can the
sovereign be indebted if he is sovereign?
• Sovereign state hard to force to repay in case of
default (especially for foreign debts), few or no
credible collateral, no bankruptcy procedure (≠
corporate world)
• Eaton et Fernandez (1995) : “challenge (…) early in
this literature (…) not to produce a model (…) but
rather to explain the phenomenon of sovereign
lending in the first place”
• Bulow (2002) even suggested their suppression?!?
(c) Kim Oosterlinck
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The Sovereign debts Paradox
• Previous statement: large risk
• But in finance, state bonds are often viewed as
THE risk free asset par excellence
• For example, in standard models such as
– CAPM re = rf + ße x risk premium
– Black and Scholes for option pricing
• Underlying idea: a sovereign state is unlikely to go
bankrupt. In the worst scenario case, it should
always be possible to raise taxes or print money…
• True?
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The Sovereign debts Paradox
However …
• Defaults exist (with many different characteristics)
and are quite frequent (Mexico 1982 and 1994-5,
Russia in 1998 etc…) , see also the list in
Reinhart and Rogoff (2009)
• Defaults can be substantial (Cf Argentina’s default
in 2001, 81 Billion USD, and Greece debt
amounting 300 billion € in November 2009)
• What may explain these defaults?
(c) Kim Oosterlinck
…
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Reasons to default
• No bankruptcy for states => decision to default 
political one, at some point political trade-off
between accrued fiscal pressure (austerity) and
default.
• Two main reasons are usually presented
• Economic (default), the most frequent
– Involuntary (Excusable?)
– Voluntary (Shleifer 2003)
• Purely political, less frequent but still encountered
– Repudiation (question legality of the loans)
(c) Kim Oosterlinck
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Many questions
•
•
•
•
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Risk??? And its corollary, long-term returns???
Size of Haircuts?
Motivations to repay? Reasons of default?
Can history bring additional insights?
Are some countries more prone to default than
others?
• What is the impact of seldom-occurring events
such as repudiation, country break-up or wars.
• Is repudiation sometimes legitimate?
(c) Kim Oosterlinck
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Long-term Returns
• Eichengreen & Portes (1986) analyse the
realized returns for 33 $ “overseas” bonds
and 31 £ “overseas” bonds traded in London
& NYC between 1920 and 1938
• Returns $ Bonds: 3,25%
• Returns £ Bonds: 5,41%
• Positive and different depending on the
country
• Figures are: Low? High?
(c) Kim Oosterlinck
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Long-term Returns
• Benchmarks needed:
– Returns $ High grade municipals: 4,11%
– On the other hand, returns £ Consols:
4,48%
• Very close to the consols
• Eichengreen et Portes (1989) extension of
the study: very similar results (but also
comparison ex ante / ex post)
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Long-term Returns
• Klingen, Weder, Zettelmeyer (2004): Period
1970-2000. Results for the period, average
yearly return = 9%: the same as for a 10 year
US government bond! => Ex post risk premium
close to zero! Why?
• 1970-1989: Past defaults forgotten, low return
because coupon yield too low in comparison to
the riskiness
• 1989-1993: The reverse! High required
coupons but not so many defaults
• 1993-2000: Small positive spreads
(c) Kim Oosterlinck
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Defaults and Haircuts?
• Long Term Returns => not too bad
• No default?
• Need to take into account that defaults may
differ in intensity…
• Default Winkler (1933): “a borrower’s failure
to pay interest, or failure to meet sinking fund
payments or maturing obligations on a
stipulated date, constitutes a violation of
agreements and is regarded in financial
language as default”
(c) Kim Oosterlinck
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Defaults and Haircuts?
• Missing payment to sinking fund a lot less
problematic than missing interest or principal
payment!
• On top of that in many cases, partial default
=> investors take a “haircut” but don’t lose
everything
• And if correct pricing of the risk, then higher
coupons than rf up to the default…
• What is the size of the haircut in case of
default? => not so straightforward…
(c) Kim Oosterlinck
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Defaults and Haircuts?
• Suter and Stamm (1992) analysis over the
1821-1975 period:
– Conversion of interest in arrears on average 66%
– Interest rates reduction of 22%
– Face value of outstanding bonds decline by
almost 18%.
• But time value of money makes comparison
difficult
• Sturzenneger & Zettelmeyer (2007), period
1998-2005 => comparison of NPV before
and after the haircut
(c) Kim Oosterlinck
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Haircuts?
• Sturzenneger & Zettelmeyer (2007), in many
case exchange of old bonds for new ones,
haircut as “harshness” on creditors (need to
take into account debtor and creditor moral
hazard)
H
NPV
NPV ( new , rnew )
1
NPV ( old , rnew )
• Results: NPV Haircut ranging from 13%
(Uruguay) to 73% (Argentina), recovery value
(% principal outstanding 30-75%)
(c) Kim Oosterlinck
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Haircuts?
• Size of haircut: result of negotiations
• Apparently no discrimination based on
nationality for haircuts but well in general
(Erce and Diaz-Cassou, 2011).
• Discrimination explained by origin of liquidity
pressure, robustness and depth of banking
system and extent of corporate world
reliance on domestic versus foreign markets
• Discrimination => political motivation
• Why do states choose to repay?
(c) Kim Oosterlinck
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Motivations to repay
• What are the costs of default?
– Reputation (desire to keep an access to
the capital markets at a reasonable costs)
– Fear of trade retaliation
– Fear to see collaterals seized
– Supersanctions: Fear of an armed
intervention (gunboat diplomacy) or the
take-over of public finances (loss of
sovereignty)
• Are defaulters indeed punished?
(c) Kim Oosterlinck
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Reputation
• Probably the most often encountered explanation
(Tomz, 2007): Reputation is THE explanation)
• To which extent do past default effect the ability to
borrow?
• If there is an effect, how long does it last?
• What’s its nature?
– No more access
– Or simply higher coupons to pay
(c) Kim Oosterlinck
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Access to the markets
• Fishlow (1985), Borchard & Wynne (1951).
Preeminence UK in 19th century, but now? Is
exclusion credible on all markets?
• Corporation of Foreign Bondholders, in the UK
and London SE rules (1825) // in France.
Proposal to recreate them at the end of 1980’s;
happened recently (Argentinean case)
• But efficiency? Flandreau and Flores (2010)
and Esteves (2007)
(c) Kim Oosterlinck
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Access to the markets
• End 19th century, begin of 20th century, major
European markets vying to get the business of
sovereigns
• France often exchanged access to the markets for
commercial concessions (with industrialists on the
board of negotiation) or for political favors (Russia
and Algesiras conference). And access conditioned
to the approval of both the Minister of Finance and
the Minister of Foreign Affairs (Feis, 1930)
• Providing there is an alternative friendly market,
exclusion cannot be enforced
(c) Kim Oosterlinck
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Access to the markets
• If access granted, what is the additional cost
of past defaults?
• Özler (1993): Commercial banks. Impact of
past defaults on terms of the loans. Panel
1,525 loans issued between 1973 and 1981
by developing countries, and history of
defaults
– Defaults prior to 1930: no impact
– Default during 1930s: impact
– Newly created countries = penalized
(c) Kim Oosterlinck
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Access to the markets
• Flandreau & Zumer (2004)
–
–
–
–
Gold-standard period (1880-1913)
Renegotiation: penalty on average 500 basis points
One year after, drop to 90 b.p.
After 10 years, 45 b.p.
• Jorgensen & Sachs (1989) compare Argentina,
Bolivia, Colombia, Chile and Peru
• Argentina only one to escape default during the
1930s. Despite that => no better terms when it
comes back to borrow in the 1950s. Good
behavior does not seem to be rewarded!!!
(c) Kim Oosterlinck
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Whose reputation?
• So far focus on the issuer’s reputation, what
about the underwriters’ role?
• Flandreau and Flores (2009) => importance of
asymmetry of information (MacGregor floated
bonds of the fictitious state of Poyais)
• Flandreau and Flores (2010) prestigious
underwriting banks => certification role
• Comparison of ex ante and ex post returns
(reliability line) => conclude prestigious houses
(Rothschild for example) strong match others
much lower…
(c) Kim Oosterlinck
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Loan issued by the
Poyais state in 1822 and
traded up till the
beginning of 1824
(McGregor)
See Flandreau et Flores
(2009)
(c) Kim Oosterlinck
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Whose reputation?
• Underwriters’ role? Flandreau, Flores,
Gaillard & Nieto-Parra (2009) => comparison
of underwriters’ role in the past and today
• Are defaults randomly distributed amongst
underwriters?
• Comparison of defaults across underwriters
(then versus now) and computation of the
strength of association using Cramer’s V
statistic (// χ2)
(c) Kim Oosterlinck
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Whose reputation?
Source: Flandreau, Flores, Gaillard & Nieto-Parra (2009)
(c) Kim Oosterlinck
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Whose reputation?
• Flandreau, Flores, Gaillard & Nieto-Parra (2009)
=> historically underwriter had also a liquidity
provision AND signaling role
• Underwriter’s reputation => lender of last resort?
• Historically, major underwriter => cherry picking
the best ≠ today
• Form of underwriting => best efforts versus firm
commitment
• Nowadays, outsourcing of the signaling to the
rating agencies
(c) Kim Oosterlinck
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Whose reputation?
Source: Berger, Herring, Szegö (1995)
(c) Kim Oosterlinck
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Whose reputation?
• In rare instances other third parties put their
reputation at stake
• During the 19th century Peru pledged Guano
(a natural fertilizer) as collateral for its
sovereign debts
• The management of the proceeds of the sale
was in the hands of famous British merchant
houses => despite political unrests the bond
prices remained stable as payment was
independent on the political winner (Vizcarra,
2009)
(c) Kim Oosterlinck
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Collaterals?
• Long history! Shetland and Orkney islands
pledged as security in the 15th century. German
monarchs forced to pledge coronation robe or
crown (Hoeflich, 1982)
• Jorgensen & Sachs (1989): Hard to implement
in practice
• Mauro & Yafeh (2003): 19th century, collateral
often railroad
– + : Easier to identify and to seize
– - : Need to change job and run a railway
company!!!
(c) Kim Oosterlinck
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Collaterals
• Other possibility need to pledge a specific
stream of revenues for reimbursement (typical
up to the 1930s for Eastern Europe)
• Nowadays extremely hard to set into place
• Countries can usually transfer their main assets
quickly abroad
• In comparison with the borrowed amounts,
collateral have a trivial value (think of Greece
what collateral could be worth the debt
amount?)
• But exceptions may exist
(c) Kim Oosterlinck
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Commercial retaliations
• How to formalize these? What would be the
exact mechanism? Boycott by citizens of
bondholders? Limitation of trade credit with the
defaulting country? Imposition of tariffs by the
country where bondholders reside? Decline of
Foreign Direct Investment (FDI)?
• Historically bondholders’ committees usually
gave priority to repayment of commercial debts
in order not to jeopardize overall payment by
aggravating the country’s current account
(Eichengreen and Portes, 1989)
(c) Kim Oosterlinck
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Commercial retaliations
• Rose (2002),debt renegotiation lead to an 8%
decline in bilateral trade (study over 50 years,
200 commercial partners)
• But Martinez and Sandleris (2011): decline
similar for creditor and non creditor countries!
• But Fuentes and Saravia (2010), decline in FDI
following default mostly concentrated in creditor
countries!
• Mitchener et Weidenmier (2004), during the
gold-standard: no commercial retaliation in the
absence of “gunboat diplomacy”
(c) Kim Oosterlinck
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Supersanctions
• Supersanctions  extreme heavy-handed
sanctions (Mitchener & Weidenmier (2010),
• Statistics gold standard: 25 defaults for 12
supersanctions
• All defaulting countries faced military risk and
fiscal control risk
• Fiscal house arrest (Egypt 1880s, Greece
1898, Ottoman Empire, 1881)
• Gunboat diplomacy
(c) Kim Oosterlinck
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Germany Supersanctions
• “The German government wants Greece to
cede sovereignty over tax and spending
decisions to a Eurozone “budget
commissioner” to secure a second €130bn
bail-out”
• “German holders of Greek bonds had
demanded international financial control of
Greek finances”
(c) Kim Oosterlinck
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Military Interventions
• For a long time: military interventions viewed as
unusual and useless (Tomz, 2007). Eichengreen
& Portes (1989), the United States intervened
only in case of a selective default discriminating
against US citizens.
• Default <=> excuse to intervene
• Palmerston doctrine: if investors wanted a British
guarantee they should have invested in British
bonds (Lipson, 1989)
• However military interventions relatively frequent
up till the beginning of the 20th century…
(c) Kim Oosterlinck
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Military Interventions
• Venezuela defaults on its debts in 1902,
unwillingness on the Venezuelan side to negotiate
=> military action by British, German and Italian
governments
• Better terms for bondholders from intervening
countries
• Fear that default would lead to military intervention
• Drago, in December 1902: “The public debt cannot
occasion armed intervention nor even the actual
occupation of the territory of American nations by a
European power” (Drago and Nettles, 1928)
(c) Kim Oosterlinck
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Military Interventions
• USA dislikes European intervention in its backyard.
Roosevelt corollary to Monroe Doctrine (1904).
• “Chronic wrongdoing, or an impotence which
results in a general loosening of the ties of civilized
society, may in America as elsewhere, ultimately
require intervention by some civilized nation, and in
the Western Hemisphere the adherence of the
United States to the Monroe Doctrine may force the
United States, however reluctantly, in flagrant cases
of such wrongdoing or impotence to the exercise of
an international police power”
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Military Interventions
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Roosevelt Corollary
• Mitchener & Weidenmier (2005) analyze the impact
of the Roosevelt corollary to the Monroe Doctrine
on bond prices
• Focus on bonds from the Caribbean and Central
America (most likely to be affected), as pointed out
by Borchard (1913) interventions on weak states
• Huge impact on bond prices (74%) for bonds under
US threat
• Mitchener and Weidenmier (2005) debated notion
of “Empire as public good”….
• Borchard (1913): military only against weak states
(c) Kim Oosterlinck
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Military Intervention
• Oosterlinck, Ureche-Rangau and Vaslin (2013),
occupied France following Waterloo. Peace Treaty
stress that France would be occupied up till 1821
but could be freed before if it managed to pay the
substantial reparations and occupation costs
(equivalent to one year fiscal revenue)
• France is basically ruined but Wellington convinces
Baring to lend to France to help her repay its due
• 1818 Treaty of Aix-la-Chapelle, foreign troops leave
• Baring “persuade the Allies to safeguard his loan by
occupying France for a further period” (Longford,
1972)
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(c) Kim Oosterlinck
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Nov-25
Jul-25
Mar-25
Nov-24
consol
Jul-24
Mar-24
Nov-23
Jul-23
Mar-23
Nov-22
Jul-22
Mar-22
Nov-21
Jul-21
Mar-21
Nov-20
Jul-20
Mar-20
Nov-19
Jul-19
Mar-19
Nov-18
Jul-18
Mar-18
Nov-17
Jul-17
Mar-17
Nov-16
Jul-16
Mar-16
Nov-15
Jul-15
French rente & British consol YTM
(1815-1825)
9%
rente
7%
5%
3%
Sovereign debts
•
•
•
Causes of economic default?
Manasse, Roubini, Schimmelpfennig (2003): “external
debt ratios measuring solvency and debt
sustainability, measures of illiquidity or refinancing
risk, measures of external imbalance and debtservicing pressures, as well as macro variables
affecting the investors’ confidence and the country’s
ability to service debt, macroeconomic (especially
monetary) instability and some political-economy
factors leading to policy uncertainty”
Can history bring additional insights?
(c) Kim Oosterlinck
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