Governance in Sovereign Debt Crises
Analyzing Creditor-Debtor Interactions
Henrik Enderlein, Laura von Daniels, and Christoph Trebesch
Many developing countries rely heavily on financial resources provided by private creditors. Consequently, in situations of financial distress, governments and private creditors often enter into a complex strategic interaction. This type of interaction takes place in an “area of limited statehood” in the sense that debtor governments show a limited ability to provide a crucial governance good: macroeconomic stability. Creditor-debtor negotiation fora thus serve as “functional equivalents” of sovereign macroeconomic management. Rather than crisis management by the government we find a specific and temporally limited form of public-private partnership (PPP).
Given the absence of an international regulatory organization or statutory regime to solve sovereign debt crises, the public-private partnership evolves in a context that lacks a “shadow of hierarchy” Instead, debt negotiations between sovereigns and foreign commercial banks and bondholders generally represent a type of nonhierarchical governance. The governance mode resembles an informal bargaining in which private and public actors are likely to have conflicting interests (cf. Risse 2008). For a public-private partnership to develop, both sides have to be interested in reaching financial stability, the key governance good to be provided.
From the perspective of governments, the key focus of this interaction is the provision of macroeconomic stability in the developing country under the constraint of servicing external debt. From the perspective of private creditors, the key focus is to limit losses from potential defaults. The resulting outcomes can take different forms: at one extreme, the private sector can be completely bailed out through official financing of a country’s sovereign debt (e.g., through the IMF); at the other extreme, the private sector—as the “residual claimant”—can be forced to renegotiate its debt at a high cut in face value. In this chapter we explore how governments and private creditors engage in PPPs and what form such interactions take during different phases of a crisis.
To this date, this type of interaction is still insufficiently understood in the crisis literature and a stronger conceptual focus is needed to uncover its nature. For a long time, the debate on public-private coordination centered on the question of how much effort from the private sector was needed. After the Mexican crisis in 1995 was solved by a large official rescue package, leaders of the G7 countries initiated a new debate on the topic, pushing for greater “burden sharing” of private creditors. In this context, “private sector involvement” (PSI) became a policy buzzword even if its exact meaning remained blurred.
For a better understanding of PPP and the role of economic governance in areas of limited statehood, it is crucial to analyze patterns of behavior on both sides—the private and the public. In this chapter we therefore follow two main goals. The first is to describe archetypal crisis devolution and identify what instruments are generally employed during different phases. We find that governments by far play a more dominant role than creditors in shaping crisis resolution patterns and setting up PPP negotiation for a for crisis resolution. Given this finding, our second goal is to analyze the behavior of governments during crises systematically, in particular the role of governance institutions in for predicting. A key insight from our empirical analysis is that debtor governments with better governance institutions are more cooperative on average. This hints at a possible link between governance effectiveness and the patterns of crisis resolution. Good governance institutions go hand-in-hand with good creditor-debtor relations and improve the prospects for successful PPPs to resolve a crisis and provide macroeconomic stability in middle-income countries.
This chapter proceeds as follows: First, pursuing the objective to build a concept of PPP during financial crises, it reviews and critically evaluates the existing literature on the interaction between creditors and governments, particularly the recent contributions on PSI, which we see as a subtype of PPP. We propose a new, more functional concept and definition of PSI based on earlier approaches, developing them further. Next, we compare our approach to the empirical reality of crisis negotiations as perceived by financial, legal, and policy experts. The second part of the chapter takes a deeper look at the behavior of debtor governments on the brink of and during debt crises. We provide a unique new categorization of government policy choices, dubbed the “Index of Government Coerciveness,” which was developed by our research team (Enderlein et al. 2010). We then use this data to provide new evidence on the role of governance in debt crisis resolution. We conclude with an agenda for future research on government-creditor bargaining processes during crises.