Sovereign Debt After Covid-19: The Wrong View

World economies were hit hard by Covid-19. The effects have been especially severe in underdeveloped countries, where economies are weaker and healthcare infrastructure is more limited. Covid-19 forced some underdeveloped economies to choose between serving their population’s needs during these difficult times and serving their sovereign debt. This has raised concerns regarding the fragility of the sovereign debt market.

International institutions and analysts are starting to pay attention to the future of the sovereign debt market. Kristalina Georgieva (International Monetary Fund) and Sigrid Kaag (Minister of Foreign Trade and Development for the Netherlands) argue that developed economies “need to do more to help countries with unsustainable debt burdens” because “low-income developing countries need strong financial support.” Similarly, Willem H. Buiter (Columbia University) and Anne Sibert (University of London) argue that the mechanisms of sovereign debt restructuration need to be revised because of the pressure that debtor countries receive when defaulting on their debt obligations. 

These two recent articles reflect a standard view of sovereign debt crises, where debtor countries that default are portrayed as victims of bad luck (e.g., negative change in economic conditions) or the bad intentions of outsiders (e.g., so-called vulture funds). And since it is not their fault, the standard view goes, rich countries should shoulder more of the burden.

The underlying problem in developing economies is not the lack of money or financial support. International reserves (US dollars) are not in short supply. If anything, central banks have been flooding markets with liquidity since the 2008 crisis. Sovereign debt problems arise because a lack of fiscal discipline and respect for contracts and private property results in high-risk premiums. Giving more financial support without solving these underlying issues is no solution; it would only postpone the debt crisis.

Debtor countries choose to seek credit on the international market. They also decide whether to reform their economic policies and institutions. Recent defaults in Argentina and Ecuador are not the result of bad luck or the bad intentions of outsiders. They are of their own doing. They lack the political will to carry out the reforms required for financial sustainability.

Would embracing the victim view of debtor countries and following Buiter and Sibert’s advice to create a sovereign debt restructuring mechanism (SDRM) “that would suspend payments during proceedings, protect debtors from creditor sanctions, and allow debtor governments to obtain new financing” improve matters? That seems unlikely. Institutionalizing the protection of debtors from creditor sanctions while not protecting creditors from debtors’ defaults would be factored into sovereign bond prices. Creditors will naturally expect more defaults from developing countries––making them less likely to lend and more likely to require a larger risk premium.

Like many others, I am concerned about the sovereign debt market in the wake of Covid-19. But providing more funds to governments committed to maintaining an unsustainable course is not a solution. These countries need serious institutional reforms.

Related Articles – Central Banking, Financial Markets, Monetary Policy