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Debt and the People, Part II: The Hot ... and Concluding Disquietudes

posted by Anna Gelpern

This last post is about old news that I have been avoiding.  Even so, it would be malpractice to omit Ecuador from even this partial snapshot of the sovereign debt landscape circa 2010.  So on with its latest debt default, and all that it has dredged up. 

In a nutshell, Ecuador announced in late 2008 that it would stop servicing two of its foreign bonds; six moths later, it bought most of them back for cash at about 35 cents on the dollar, effecting substantial debt relief.  Three things about the episode bear emphasis.  First, Ecuador specifically refused to claim that its debt was unsustainable by IMF metrics conventionally used as a threshold for sovereign debt relief in the absence of a formal bankruptcy regime.  Second, on the eve of the default, a Presidentially-appointed audit commission deemed the debts irregular and illegitimate.  However, not all the debts condemned by the commission were then formally renounced by the government.  Third, instead of walking away from the debt, Ecuador ended up reverting to market mechanisms to buy it back at a discount.

These elements make the episode extremely unusual even by the quirky sovereign debt standards, for three reasons.  First, no state in recent memory has succeeded in claiming debt reduction on illegitimacy grounds alone, or even primarily; and barely any have tried.  States tend to lead with “inability to pay”; creditors counter with accusations of “unwillingness to pay”; then it gets intractable and boring until a deal is struck at a price that makes it worth everyone's while to agree to disagree.  Second, Ecuador’s process for determining illegitimacy--the integral audit commission, or CAIC--was original.  CAIC members were government officials, local and and foreign debt relief advocates; they took a little over a year to review thirty years of debt management, and produced a 150-page catalog of irregularities ranging from missing authorizations, faulty paperwork and submitting to foreign law, to Paul Volcker's U.S. interest rate hike.  Some accusations have received disproportionate attention (they are picturesque), but this has detracted from the core thrust of the report, which is a broad-based indictment of North-South debt relations.  Third and last, the connection between the report's findings and the government's response is not straightforward.  After all, theories of debt illegitimacy generally contemplate nonpayment, not partial payment, or cash buybacks at market price.  Was this repudiation or partial assumption?  A snub of the markets, or "elegant" use thereof?

Several recent articles and steady blog traffic enrich the voluminous primary sources feeding the controversy (including the disclosure document here; the audit commission findings here).  Much of the commentary--including this article by Lee Buchheit and Mitu Gulati, this from Adam Feibelman, and this from Arturo Porzecanski--are critical, essentially stipulating that Ecuador’s default was opportunistic and damaging to the sovereign debt market and its regulatory infrastructure, including national and global public institutions.  But others have praised Ecuador’s strategy for the debt relief it has achieved; and the market reaction suggests a grudging admiration.

I have avoided commenting on the episode until now because I am honestly unsure what to make of it.  Surely Ecuador has defied what appear to have been the widely accepted norms of sovereign borrowing since that market came back from the dead in the 1970s.  The authorities do not deny this; they challenge the essential legitimacy of these norms.  One of the interesting contentions in the CAIC report is that the debt is illegitimate not (or not just) for government corruption, procedural irregularities, and waste of proceeds, but for its size alone--in effect, for equitable and political unsustainability.  Whether Ecuador's leaders are pursuing the argument out of genuine (even religious) conviction or out of crass opportunism (political savvy?) is beside the point.  To the median voter today, it sure looks like poor people and poor countries have done less well by financial globalization than rich people and rich financial conglomerates.  That the poor might have been poorer yet without the Great Vampire Squid is nobody’s first argument.  And while Ecuador’s particular illegitimacy contention is breathtakingly broad, if the project is to indict the system, why hold back?  Last, just because Ecuador—a politically messy oil exporter, record-setting serial defaulter, and serial debt relief beneficiary—may be an iffy protagonist for renegotiating global norms, does not diminish its success where more photogenic actors, more modest claims, and multiple popular campaigns have failed before.

Crucially, Ecuador has succeeded by getting down and dirty, using the very market structures it decries … meaning, I suppose, that the capitalists sold Ecuador the rope with which it hung them. (Though apparently, Lenin never said this.)  Ecuador also succeeded in immobilizing the almighty official sector (the IMF, other multilaterals, and rich governments).  Thus when asked about Ecuador, the Fund responded that it cannot take sides in disputes over legality.  This is because, whatever one might think of the doctrinal merits of Ecuador's claims, it is simply not the IMF’s institutional competence or cultural inclination to accept or reject them; they are not arbiters of international law, progressive or otherwise; they are sustainability nerds with no overt political mandate.  And so they and everyone else blush and mumble "no comment."

So where does Ecuador leave sovereign debt? 

One narrow lesson from the incident is that by establishing an internal process and claiming illegitimacy, a state can short-circuit the vast, intractable legal and policy debates over the so-called Odious Debt doctrine, which have consumed the international establishment and the legal academy.  Whether Ecuador met what might be the elements of such a doctrine in its classic formulation (debt incurred without the consent of the people, not for their benefit, and with the creditors' knowledge is excluded from state succession) is suddenly beside the point, since Ecuador has redefined every element.  This reminds me of the way in which the United Nations Security Council short-circuited seemingly intractable legal and political debates about sovereign bankruptcy at the IMF by immunizing Iraq's oil proceeds from attachment.  (I discussed the episode here.)  But the lesson is narrow because distressed market conditions and Ecuador's relatively abundant cash reserves may have made the repudiate-repurchase operation uniquely feasible at the time; this is a rare confluence of events.

Ecuador also serves as a stark reminder that debt sustainability is among other things--or above all--political sustainability.  I am not so much circling back to "willingness to pay" (useless), but reiterating what others have said about the political boundaries of "inability to pay."  California's creditors are getting compensated (adequately, one hopes) for its inability to raise taxes.  State insolvency is a matter of cashflow politics; these days no one auctions state buildings and citizens' vineyards.

The previous point also ties in with another tiresome debate in the sovereign debt world:  whether in the absence of conventional enforcement and bankruptcy, sovereigns borrow and creditors lend in reliance on indirect enforcement or reputational sanctions.  Everyone acknowledges, and some have rightly stressed, that Ecuador was getting no new money in the markets, and had limited, if any prospects of getting any in the foreseeable future.  So maybe Ecuador 2008 was just a case of extreme reputational indifference, combined with righteous fervor, domestic political and external market opportunity, finally tipping the balance to nonpayment.  If so, this lesson too is narrow.

The biggest and weirdest lesson of all, perhaps, is that the absence of an intellectually coherent and broadly legitimate system for resolving sovereign debts keeps producing disjointed results that leave just about everyone discombobulated.  Contractual fixes that have been at the center of policy attention might emulate bankruptcy mechanics, but by definition, cannot achieve the legitimacy of a public law move.  Quoth the CAIC report, "Our only debt is with the people."  The only way to take political risk out of sovereign debt is to cede sovereignty.  I did not see it happening in 2003, and I do not see it coming now--Ecuador, Greece, Iceland, and even market support notwithstanding.  Nor am I convinced of its merits in any currently conceivable institutional set-up. 

... And so short on answers, I sign off, with many thanks to my generous hosts and indulgent readers.


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