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Types of lenders and of loans in sovereign borrowing

The external debt burden of a country is the money owed by private debtors (companies) and by the government to foreign creditors. Roughly 62% of external debt in 2004 was owed publicly and 38% owed privately (CADTM 2005). There are various reasons why a government will borrow. We will focus on particular reasons for borrowing which are most relevant to sovereign debt crises. One reason is if export revenue is insufficient to buy all the required or desired imports. This shortfall can be covered by national reserves, but, failing that, a loan may be sought. Another is for large government investments such as in building essential infrastructure. Yet another is in order to repay other debt.

Governments may be debtors indirectly. For instance, they may be a guarantor for a public or private enterprise that directly undertakes the loan. As guarantor, the government affirms that they will pick up the tab in case the borrower defaults. This is done because governments are usually seen as less risky than other borrowers and this may lower the interest rate at which the loan is given. These are contingent liabilities for the government – it may be liable if the direct debtor defaults on debt.

A debt crisis occurs when the usual creditors lose confidence in the ability of the sovereign to repay and therefore are unwilling to continue lending.

The main types of lenders to sovereign borrowers are commercial banks; multilateral institutions such as the IMF, the World Bank and various regional development banks like the Asian Development Bank, the African Development Bank, and the Inter-American Development Bank; official loans from governments (bilateral loans), generally developed country ones; and lastly, ordinary bond holders who buy on the market.

Bilateral debt is generally of two sorts – ‘aid debt’ and export credits. Aid debt is loans given to finance infrastructure projects and other development works. With export credits, which constitute the bulk of bilateral debt, the debtor country imports goods or services from the companies in the creditor country. For example, the debtor country may ask a foreign company to undertake some construction work. If the debtor country cannot pay the company at the conclusion of the construction, the creditor government pays the company. The creditor government pays this amount as a loan to the debtor country and expects repayment. The export credit is the guarantee by the creditor government to domestic export firms that ensures they will get paid if they export to the debtor.

The poorest countries often do not find private agents willing to lend to them. They borrow from multilateral and bilateral lenders, generally at concessional rates. Loans from governments include the Official Development Assistance (ODA) funds disbursed by the OECD group of developed countries via the Development Assistance Committee (DAC).

Many ‘emerging markets’ have begun issuing bonds as a substantial form of borrowing. Emerging markets include about 25 or so developing countries that are rapidly industrializing and that are commonly considered somewhat in-between developed and developing country status. The bonds are sold to ordinary investors on the market. The government borrows money through the bond, and agrees to repay it with interest upon maturity to the bond holder. The bond market trades in these bonds between buyers and sellers based on their assessments of what the bond is likely to fetch upon maturity. Commercial and investment banks often act as intermediaries in the issuing of bonds by emerging economies. They help structure the bond offering, market the initial issue and underwrite the issue as they effect their sale to first buyers (Herman 2008: 15).

All in all, roughly 22% of external debt in 2004 was owed to multilateral institutions, 20% to bilateral governments and 58% to private creditors (CADTM 2005).

Credit markets and risk

In the general operation of a credit market, the lender expects that, some of the time, a borrower will fall behind on payments or will default altogether, unable to repay the outstanding amount. This risk is a normal part of credit markets. Based on their assessment of the riskiness of a loan to a given client, creditors charge different levels of interest. They charge higher interest rates for riskier clients. If the loan is fully and unproblematically repaid, some of the higher interest collected can be set aside as a loan loss reserve. This reserve makes up for cases of default.

The existence of risk acts as an imperative on lenders to judge the creditworthiness of borrowers, and the likely success of the investment planned by the borrower. Insulation from existing risk leads to moral hazard: the private creditors, expecting that they are insulated from adverse consequences of risky lending, act less carefully than they otherwise would. In such cases, there will be over-lending.

One element contributing to the accumulation of developing world debt is that their creditors have been insulated from risk and have therefore over-lent. Before the advent of the Bretton Woods institutions, risk was allowed to play some role in sovereign borrowing. When sovereign states defaulted, their lenders often bore the cost. There were, of course, occasions of military action to recover debts forcibly, and these shielded creditors from risk. Yet at the same time, much money was simply lost. There were many default negotiations concluding in a debt reduction. Here are a few examples of negotiated debt reductions and unilateral debt defaults. The British and French governments defaulted in the 1930s, saying that the welfare of their populations were more important than honouring the presumption to fulfil contracts in this instance. In the 1940s, nine US states suspended interest payments when their main export – cotton – could not fetch enough of a price. The 1953 London Accord halved Germany’s foreign debt (Raffer 2007: 87-8).

In the 1970s however, creditor governments bailed out their banks even when they did not adequately take account of risk. Private creditors thus received the signal that they did not need to cautiously assess risks, be selective in lending, and be prepared to suffer losses and to plan accordingly. An illustrative example is the case of US banks’ lending to Indonesia in the early 1970s. US government agencies warned private creditors about the bad state of existing Indonesian debt. The IMF placed a ceiling on the Indonesia’s external borrowing. Yet, private creditors used technical tricks to get around these restrictions, and continued to lend. When the expected crisis developed and it seemed the creditors would be out of pocket, the US government indeed bailed them out (Raffer and Singer 2001: 162). Bail outs by creditor governments as well as by the multilateral institutions led to a climate of over-lending.

What is the usual recourse when there is inability to service a debt?

Countries generally have legal mechanisms for handling difficulties in servicing debts. These serve debtors who are individuals, corporations, or even sub-sovereign bodies such as a municipality. The mechanisms can include arbitrations between creditor and debtor to work out a restructuring of the loan – perhaps to change the term of the loan, or reduce interest, or postpone payment. Debt reductions are also possible. For corporations, there may be debt-equity swaps, where the creditor erases some debt in exchange for shares or control in the company. A loan can be refinanced by obtaining a new loan. Insolvency occurs for a person or an organization when financial assets are insufficient to cover financial liabilities. A debtor claiming insolvency can appeal to be legally declared bankrupt.

In general, law surrounding bankruptcy balances the principle of honouring the debt rightfully owed to creditors against the principle of ensuring that one must not be forced to fulfil contracts if that leads to inhumane distress. Such distress would include the seizure of basic means of sustenance for an individual, for example. If the debt cannot be met without causing inhumane distress, then some level of repayment less than full is negotiated through an arbitrator and both debtor and creditors are bound to it.

There are some special concerns when the agent seeking bankruptcy is a governing body. The US Code, for example, deals with such agents separately in chapter 9 of its title on bankruptcy. What are commonly referred to as ‘chapter 9 proceedings’ allow for the adjustment of debts of a ‘municipality’ (essentially, a sub-sovereign body within the state, such as a city or a county). Given that the financial future of the municipality will affect the lives of its residents, those who have a right to be heard during a hearing on a possible bankruptcy, include municipal employees, local residents and non-resident owners of real property among others (US Code title 11 ch 9). This allows an avenue for residents to voice their concern if they would be caused great distress by possible actions taken against the municipality.

Certain revenues and assets of the municipality are immune to seizure for the sake of repaying debts. These are to do with basic services that a municipality is expected to provide for its residents, such as transportation or utilities (11USC 902, 927). This is one avenue whereby inhumane distress to residents is proscribed.

Moreover, unless the debtor municipality consents to this, the court may not interfere with the political or governmental powers of the debtor, or with its property or its use or enjoyment of any income-producing property (11USC 904). This is to respect the value of sovereignty. Unlike other debtors such as corporations, municipalities are representatives of citizens and their means of self-government. This value of municipalities to their citizens remains protected.

There is no international legal mechanism for dealing with insolvency of sovereign states. This absence is another prominent factor contributing to the large debt burden of developing countries.

References

CADTM. (2005). Les chiffres de la dette. <http://www.cadtm.org/IMG/pdf/vademecum2005b-2.pdf>Accessed on 31-07-2008

Herman, B. (2008). “Introduction: the players and the game of sovereign debt.” Dealing Fairly with Developing Country Debt. C. Barry, B. Herman and L. Tomitova (eds), Wiley-Blackwell.

Raffer, K. (2007). “Risks of lending and liabilities of lenders.” Ethics and International Affairs 21(1): 85-106.

Raffer, K. and H. Singer (2001). The economic North-South divide: six decades of unequal development. Northampton MA, Edward Elgar.