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Protecting Against Sovereign Defaults

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When Sovereigns Go Bankrupt

Part of the book series: SpringerBriefs in Economics ((BRIEFSECONOMICS))

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Abstract

Chapter 2 analyzes the various means used by creditors to mitigate sovereign risk well in advance – that is, when countries issue bonds, sign loan agreements, or are at an early stage of their borrowing cycle. Section 2.1 looks at sovereign bond and loan covenants: it presents the clauses that enable creditors to enforce contracts, secure repayment flows, avoid subordination, neutralize the risk of repayment on unfavorable terms, obtain specific guarantees, and make debt renegotiations easier once a default has occurred. The main provisions studied here are the choice of law, arbitration, currency, pari passu, and collective action clauses (CACs) as well as pledges, negative pledges, and “inflation-proof” clauses. Section 2.2 addresses the various insurance and insurance-like instruments that investors can rely upon to hedge against default risk; these include sovereign risk insurance covenants, contracts of guarantee offered by multilateral agencies, and credit default swaps (CDSs).

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Notes

  1. 1.

    This chapter intentionally disregards three basic aspects of sovereign lending: the interest rate, the maturity, and the amount loaned (the riskier the country, the higher its interest rate, the shorter its debt maturity, and the smaller the amount issued). These features are analyzed in Chap. 4.

  2. 2.

    These two approaches were not entirely exclusive. Prior to their military intervention in Venezuela in 1902, Great Britain, Germany, and Italy had proposed to submit their dispute to a neutral tribunal (Fischer Williams 1925, pp. 311–312).

  3. 3.

    Article 59 of the statute for the PCIJ was provided for by article 14 of the covenant of the League of Nations.

  4. 4.

    That distinction accorded with Grotius’ analysis, which opposed acts of the state qua sovereign and acts of the state qua private person.

  5. 5.

    During the years that followed, other countries passed similar laws – for example, United Kingdom and Canada in 1978 and 1982, respectively (Brownlie 2003, p. 326). France, Germany, and Switzerland had revised the principle of absolute immunity as early as the nineteenth century (Delaume 1957, pp. 203–204). These shifts support the view that creditor nations have long promoted a restrictive theory of sovereign immunity.

  6. 6.

    The hegemony of New York was driven in part by the enactment in 1984 of “Section 5-1401 of New York’s General Obligations Law, which validates stipulations of New York law without a requirement of a reasonable connection between the transaction and New York” (Committee on Foreign and Comparative Law 2013, pp. 5–6).

  7. 7.

    In the NML v. Argentina decisions (28 March 2013), the French Supreme Court tightened the conditions applied to waivers of sovereign immunity from execution.

  8. 8.

    Borchard (1951, pp. 83–91) provides many examples of security clauses.

  9. 9.

    Recall that “international original sin” refers to the inability to borrow abroad in domestic currency. This problem affects not only developing and emerging countries with a poor track record and high inflation but also small economies that, despite their fiscal and monetary credibility, have only an embryonic financial system (Eichengreen et al. 2005b, pp. 234–238).

  10. 10.

    This reasoning applies also to foreign currency-indexed debt and to bonds or loans that incorporate gold clauses (in the nineteenth century and during the interwar years) or foreign exchange clauses.

  11. 11.

    http://www.state.gov/s/d/met/releases/198355.htm

  12. 12.

    See Choi et al. 2012 (pp. 159–166) for an overview of the different CACs.

  13. 13.

    The issuance by Mexico of bonds with both types of CACs in February 2003 served as a catalyst for the inclusion of collective modification and collective acceleration clauses in most debt covenants.

  14. 14.

    Chile and Colombia defaulted in 1826 and Mexico in 1827 (CFB 1878, pp. 52–53).

  15. 15.

    Credit default swaps are not equivalent to insurance contracts for two main reasons. First, the “buyer does not have to own the underlying security, or otherwise have any insurable interest in that security”; second, “the buyer does not in fact have to suffer any loss in order to recover on the CDS” (Garbowski 2008, p. 4). An examination of the use of CDS instruments for speculating or basis trading purposes is beyond the scope of this book.

  16. 16.

    http://www.sovereignbermuda.com/claims_history/claims_history.html

  17. 17.

    This loan was made to finance the completion of a power plant.

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  1. Corbeil-Essonnes, France

    Norbert Gaillard (Economist and independent consultant)

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Gaillard, N. (2014). Protecting Against Sovereign Defaults. In: When Sovereigns Go Bankrupt. SpringerBriefs in Economics. Springer, Cham. https://doi.org/10.1007/978-3-319-08988-1_2

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