To Pay the Piper

• Author: Luis A.V. Catão and Rui C. Mano

To Pay the Piper Finance & Development, December 2015, Vol. 52, No. 4

Luis A.V. Catão and Rui C. Mano

Countries face a far higher interest rate premium for defaulting on their sovereign debts than previous wisdom suggested

Think of a government that defaults on its debt to foreign investors and, a few years later, negotiates a reduction of the original debt and is about to resume borrowing from capital markets. It faces a number of questions. Should it expect to be penalized for the default and pay an interest rate on new borrowing that is higher than justified by the fundamental state of its economy? If so, how large will such a “default premium” be? And how long will it take for that country to reestablish its creditworthiness and eliminate this default premium?

These are important questions for several reasons. The size and persistence of any default premium determines the debt service burden the country will carry into the future. The premium may also affect any adjustment programs a defaulting country might undertake with multilateral institutions like the IMF to enable it to stay afloat after losing market access. If the default premium is high and persistent, it may take time for the country to reduce reliance on multilateral loans. And if the default premium lasts a long time, it suggests that investors do not easily forget the debt they forgave.

However, whether defaulting sovereigns actually pay a nontrivial interest rate premium has been long debated. With the greater availability of historical data starting in the 1980s a few researchers tried to answer the question empirically. Much of that research suggests that countries either pay a relatively trivial premium for defaulting on their debts or one that is short-lived. For instance, papers by Eichengreen and Portes (1986), Lindert and Morton (1989), and Ozler (1993), among others, found only tiny differences in the interest rate paid by countries that defaulted in the 1930s and those that did not—no more than 25 to 30 basis points (one basis point is 1/100th of 1 percent). In contrast, studies that relied entirely on emerging market data from the 1990s and 2000s (such as Borensztein and Panizza, 2009) found large interest rate premiums of up to 400 basis points on average when countries started to borrow again in private markets, but also found that the premiums virtually disappeared within two years. Only in a few cases in which losses imposed on creditors (so-called haircuts) were exceptionally large did premiums persist (Cruces and Trebesch, 2013).

Still, most governments seem to go out of their way to avoid defaults, which seems incongruous if the penalty is relatively trivial for failing to repay borrowing on the original terms. Clearly, there are other potential risks to...