26 October 2016
Greece barely managed to make a significant payment last month, and even larger payments fall due throughout the summer. Photo: Bloomberg
Greece barely managed to make a significant payment last month, and even larger payments fall due throughout the summer. Photo: Bloomberg

How to default on sovereign debt while minimizing damage

The financial brinkmanship over Greece’s debts has raised the question of whether (or when) the country will default.

To be sure, it would be far better for Greece and its creditors to reach a negotiated solution. But that outcome is far from guaranteed.

The Greek government barely managed to make a significant payment last month, and even larger payments fall due throughout the summer, starting in June with an installment of more than 1.5 billion euros (US$1.67 billion) on its liabilities to the International Monetary Fund.

As Greek officials consider their options, they would do well to bear in mind that there are better and worse ways to default on sovereign debt – especially given countries’ desire to reestablish their creditworthiness as soon as possible.

In the coming weeks and months, the Greek government would be wise to consider three guidelines:

Don’t name-call. Default is painful, even if it does turn out to be the right choice in the long run. In the midst of all that pain, it is tempting to point fingers. But it is important to resist this urge.

More likely than not, sovereign debtors will have to interact with the same creditors and international actors again.

It is hard to know how much harm Argentina’s undiplomatic pronouncements during its default saga did to its efforts at navigating the United States’ legal system; what is clear is that its ill-considered official rhetoric did not help its case.

In the Greek context, there has already been enough name-calling for several debt crises. Issuing a statement of regret at the inability to reach a negotiated solution, offering clear short- and long-term plans to manage the default, and outlining a compelling strategy for recovery and growth would be far preferable.

Explain yourself. In the aftermath of a default, it may seem that no one is listening to even the most rational of explanations. Creditors will probably insist that the default was a terrible mistake and argue that recovery is impossible unless the decision is quickly reversed.

Some commentators may actually wish an insubordinate country ill, if only to prove a point or teach would-be followers a lesson. But other actors, including potential future creditors, could be more open to persuasion.

Creditworthiness is generally understood to depend on two things: willingness to pay and ability to pay. A default is a concrete demonstration of the limits of a state’s willingness to pay, at least in the short term.

And yet things are not necessarily so black and white. A country that is defaulting can emphasize that the rejection of a particular debt payment does not necessarily entail a rejection of the logic of debt payments as a whole.

In the case of Greece, some investors and commentators may sympathize with the authorities’ contention that austerity measures have only hampered its recovery. They may accept that a default could be part of a policy package designed to improve the country’s economic fundamentals and thus its capacity to repay its debt in the long term.

Repay some debt. It sounds counterintuitive, but countries in default should consider paying some of their debts – on their own terms and on a graduated basis – as a way to rebuild creditworthiness.

If the explanation for a default includes an assertion that payments should be tied to economic recovery, then it can make sense to specify the conditions for resuming payments – and follow through when the conditions are met.

To be sure, this could weaken a debtor’s leverage – the promise of future repayment – in bringing creditors back to the negotiating table. But it would also demonstrate to old and potential new creditors alike not only a capacity, but also a willingness, to make payments, thereby creating incentives for external actors to support economic recovery.

Even after the Soviet Union’s repudiation of czarist Russia’s debts – perhaps the 20th century’s most notorious (and most misunderstood) debt default – certain creditors expressed interest in lending to the new regime, in part because Soviet agencies repaid debt that they considered legitimate.

More recently, Ecuador continued payments on the small portion of debt that it considered acceptable after defaulting on its international debts in 2008 (under circumstances far less extreme than Greece’s). This repayment contributed to a slow improvement in its credit rating and its eventual return to international capital markets in 2014.

Even if Greece reaches an agreement in time to make the first IMF installment due in early June, it may not have enough to cover the even larger payments required of it through the rest of the summer.

Chances are that the Greek government and its creditors will be back at the negotiating table again.

A unilateral default, one hopes, will not be necessary. But if Greece does take that route, it should seek to make its path as smooth as possible.

Copyright: Project Syndicate

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Professor of law at Cornell University

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