Sovereign Bankruptcy

Suzanne Miller

History Of Sovereign Defaults And Bankruptcies

It has long been held that buying the bonds issued by governments, known as sovereign bonds, makes good sense for investors in search of secure returns because of the inherent strength in the underlying guarantee. For example, a business may end up in a position where it can no longer pay off debts, but how often does that happen to an entire country? In the case of a rich, developed nation, such as the U.S., the answer is virtually never. That is why the bonds issued by the U.S. government are sought as a safe haven in uncertain times.

Naturally, the stronger a country’s economic health, the stronger the underlying guarantee of repayment. Yet sometimes a country’s entire economy becomes too weak for the government to meet its obligations to investors at home and abroad. When a country doesn’t have the money to make payments on its debts, or to pay the debts when they come due, it defaults on its debt. A country – just like a business – that can’t pay its debts is considered bankrupt.

This problem famously occurred in the 1980s during the Latin Debt crisis, when loan defaults by several countries, led by Mexico, totaled $251 billion by the end of 1989. More recently, Argentina defaulted on more than $130 billion of debt in December 2001. That was 25% of the emerging market debt outstanding at the time – making it the single biggest sovereign default ever.

But sovereign defaults are nothing new. In the 1820s and again in the 1930s, Latin American countries also suffered massive defaults. And in the past, European nations have used sovereign defaults as an excuse to invade foreign territory. For instance, in 1861, Britain, France and Spain invaded Mexico when it defaulted on its debt. In 1902, Great Britain, Germany and Italy sent a joint naval expedition to the Venezuelan coast where they blockaded seaports and captured Venezuelan gunboats. Argentina’s foreign affairs minister, Luis Maria Drago, protested, laying the groundwork for the Drago Doctrine – in essence an extension of the Monroe Doctrine – which maintained that no public debt could be collected from a sovereign Spanish American state by armed force or occupation by a foreign power. A modified form of the Drago Doctrine was approved at the Hague Conference of 1907.

Why Do Countries Default?

There is no one hard and fast reason why countries default on their debt. It is usually a combination of factors that include:

  • a high level of foreign debt,
  • sluggish domestic growth,
  • problems in domestic economic policy,
  • rising interest rates,
  • currency devaluations, and
  • a collapse in commodity prices for commodity-exporting countries.

These problems might be caused by an economic slowdown among developing countries. For instance, when industrialized countries experience an economic slowdown, this can ultimately make debt servicing much more difficult for emerging economies because revenue from exports typically fall away at such times.

Currency instability can be a big factor on its own. Domestic currencies pegged to the dollar and other such mechanisms can collapse when the exchange rate gets massively overvalued. Many ascribe Argentina’s accelerated collapse in late 2001 to the breakdown of its rigid currency board and the subsequent big devaluation in the country’s domestic currency, the peso.

Often, a sovereign default is a cumulative event. In August 1982, the Mexican government was suddenly unable to roll over its commercial debt as a series of economic problems came to a head. The government had borrowed heavily to fuel growth at home. That plan unraveled when the U.S. government raised interest rates to slow domestic inflation. This led to a rise in the value of the dollar, causing runaway inflation in Mexico as it imported goods at a higher price from the U.S., and making servicing interest on Mexican debt with foreign banks horribly expensive.

So, Mexico had to borrow new funds to replace loans that were due. Overnight it went from being a net borrower to a net repayer. Shortly after, other sovereign debtors in Latin America sought rescheduling agreements, too. This coincided with a sharp rise in world interest rates in the early 1980s, which added to the debt burden of countries because most of their borrowings were indexed to short-term interest rates. Meanwhile, exports were hurt as developing countries struggled with falling commodity prices after a decade-long rise in the 1970s.

What Happens When Countries Default?

When a business defaults on its debt, it generally either declares bankruptcy voluntarily in court, or its creditors have it declared bankrupt by a court. Bankruptcy law varies from country to country, but the purpose of placing the issue in the hands of the legal system is to give creditors a chance to recoup some of the money they are owed, and to allow businesses an opportunity to try to reorganize and get back on their feet. The court in different ways will oversee the process of rescheduling debt payments, restructuring the debts, or reorganizing the business.

To date, there has been no coordinated international system for dealing with sovereign defaults. Countries that can not pay their debts try to have them rescheduled, or try to negotiate a write-down, or reduction, of the total amount of debt. The majority of negotiations and workouts have historically been done on an ad-hoc basis between creditors and the government. To renegotiate official debts, or the money owed by one country to another, debtor nations have to deal with the so-called Paris Club, a group of rich creditor nations. To renegotiate commercial debt, or money owed to private creditors, such as banks, countries have to deal with a group known as the London Club.

In some cases, where a country appears to be rapidly approaching a default, or the size of the debt owed means a default could disrupt the financial markets and the stability of the country itself, the International Monetary Fund may step in. The multilateral institution has in the past made emergency loans to help countries in such situations, in a move often referred to as a bailout.

The IMF doesn’t help all countries that default. For instance, in 1999 Ecuador defaulted on $6 billion in Brady bonds, with no help from the IMF. But it does have a history of paying big money to help others. So far it has paid out some $250 billion. The IMF has been heavily criticized for its long track record of bailouts that have failed to show discernable long-term benefits, or even failed in their immediate objective of stabilizing the exchange rate, as happened in East Asia in 1997, Russia in 1998, and Brazil, in 1999. Indeed, IMF critics contend bailouts typically prolong and exacerbate economic problems, especially for lower-income nations, because a bailout is just another set of loans to add to their debt burden. You can read more about debt relief and HIPC here.

A persistent criticism of bailouts has also been the moral hazard problem, where the lender loans money carelessly, knowing that if things go wrong, there is a good chance of a bailout. This excessive lending, critics claim, has played an important role in bringing on some of the recent crises. This was the widely held view in the case of Russia, which defaulted on its debt in 1998. Creditors believed it was “too big to fail,” especially since the West would be worried about instability in a nuclear power; when, in spite of a large bailout in July, the country defaulted on its loans in August as the ruble collapse, there was a major sell-off in the emerging markets, in response to the recognition of the seeming limits on bailouts.

A New Proposal

Things took a new twist, however, when Argentina defaulted on more than $130 billion of debt in November 2001. The IMF declined to give the country more money as the economy collapsed, marking a major policy shift. The IMF had been closely tied with the policy stances of Argentina throughout the 90s, often seemingly trotting out Argentina as it’s A+ student. Even when the new Bush Administration came in strongly questioning bailouts, the IMF continued to lend to Argentina. This time around the IMF declined to give more money to Argentina because it believed a bailout was not enough to avert an imminent financial collapse. But many saw this move as a clear acknowledgment of the IMF’s dismal record in bailing out other economies that also ended up needing more than just a handout.

Around the same time, following four years of sustained opposition, often involving heavily publicized anti-globalization demonstrations directed at the IMF, World Bank and World Trade Organization, the IMF bowed to international pressure and decided to try a new approach to defaults. In November 2001 the IMF produced a new policy proposal, a sovereign debt restructuring mechanism (SDRM), a procedure akin to bankruptcy.

The IMF proposal would allow a debtor country to request a temporary standstill on its debt repayments while it negotiates a restructuring acceptable to a majority of creditors. The consent of the majority (two-thirds or more) would bind the minority creditors. The restructuring plan is meant to approximate the U.S.-style Chapter 11 bankruptcy code. The IMF has proposed that a “super-majority” of creditors approve the plan rather than all creditors because workout groups can involve thousands of individual claims, and there has been a fear that a few “hold-outs” could stop a restructuring, perhaps in an attempt to extract a better deal for themselves. On the other hand, the requirement that all creditors agree originated in part from instances where a majority, or even a supermajority, approved restructurings that worked to their advantage, but to the disadvantage of the minority. There is a concern that under the IMF proposal, this problem will resurface.

How workouts currently operate:

The process for current workouts is many-layered, involving formal negotiation with a creditors’ committee, formal or informal consultation, as well as legal structures ranging from formal amendment of existing debt contracts to exchange offers. The restructuring process is time-consuming because most bond contracts provide that their payment terms cannot be amended without the consent of “each bond affected thereby”. That means that all creditors must agree.

There are different mechanisms for debt workouts. Some recent defaults have involved a class of debt known as Brady Bonds. Other workouts have involved exchange offers.

Brady Bonds: These instruments were named after U.S. Treasury Secretary Nicholas Brady, who invented them in the late 1980s as a way of addressing the lingering problems from the debt crisis of the early 1980s. The bonds represent the restructured bank debt of Latin American and other emerging nations that over-borrowed from U.S. institutions. They are typically backed by U.S. zero-coupon bonds of different maturities. The bonds enable debtor governments to reduce their principal, interest and interest arrears. Countries involved in the Brady Plan restructuring have included: Argentina, Brazil, Bulgaria, Costa Rica, Dominican Republic, Ecuador, Mexico, Morocco, Nigeria, Philippines, Poland and Uruguay.

Exchange offers: Debtor countries such as Russia, Ecuador, Pakistan and the Ukraine have been able to restructure sizeable portions of their debt through the use of exchange offers, which replace old debt with new debt that typically grants more generous terms to the debtor country. Ecuador represented a turning point in restructurings because it used certain amendment clauses, called majority action clauses under English law, as well as exit consents to encourage full participation from those in the exchange. The “majority action” amendment was critical to driving the restructuring plan through because while the majority of bondholders participated in the deal, there was still a group of holdouts that theoretically could have attempted an Elliott-style litigation process (in which the buyer of a few bonds attempts to extract better treatment, as a condition for allowing the restructuring to go through). Under the terms of Ecuador’s Brady bonds and eurobonds, a 75% majority of bondholders were able to change non-financial terms in the old bonds. The majority voted on amendments to the old bonds that made the bonds unattractive to potential holdouts.

There are several problems with the current workout process:

  • Coordination problem: Debt workouts are typically hampered by a broad array of claimants. There can be hundreds of different bondholder classes, for instance, competing for a payout. In sovereign debt, there are often ambiguities about which creditors are senior to other creditors. International creditors are a powerful force because they are the source of much-needed capital in developing countries. Critics of the IMF “bailout” legacy often contend that these investors get favored treatment (say, relative to domestic creditors) when countries gain assistance packages because these are the creditors with which the IMF is concerned; others believe that without the IMF, governments would discriminate against foreign creditors.
  • Getting everyone to agree to one payment plan can be onerous, partly because of their conflicting interests and perspectives, with a plan agreed to by most bondholders being less advantageous to others, or not adequately respecting priority claims. Some believe that the coordination problem has become worse in recent years; in the 1980s Latin American crisis, most of the debt was held by a few banks.
  • Holdouts: In 1996, Elliott Associates LP sued Peru after it closed on a financial restructuring plan under a Brady agreement. Elliot Partners held about US$21 million of Peru’s commercial bank loans and did not participate in the deal. In 2000, Elliot Associates won its legal claim, unprecedented in international workouts. This has been one of the only “rogue creditor” case studies to date. Nonetheless, it has played an important role in the drive to establish a formal international bankruptcy solution, The IMF and others have worried that the creditor’s actions threatened, although they did not ultimately disrupt, Peru’s financial restructuring under the Brady plan. The IMF's plan seeks to deal with the potential of individual creditors holding out for their own interests rather than cooperating with a broader group.
  • Squeezes: In other cases, however, where unanimity has not been required for restructuring, minority creditors have been “squeezed,” with their interests not adequately preserved, in the view of these creditors.

The Collective vs. The Statutory Approach

Those supporting a collective approach to sovereign bankruptcies would prefer to leave the restructuring of sovereign debt as an informal process of negotiation. Those who prefer a statutory approach would like to see some formal law or code written to guide sovereign defaults.

The U.S. Treasury is pushing for the insertion of collective action clauses in sovereign debt contracts that would, in effect, force all creditors to go along with a restructuring approved by a majority, or a supermajority (say two-thirds). While there are concerns about how such clauses can be inserted into already existing debt contracts, and what to do if many contracts do not yet have such clauses, there are more fundamental objections to the approach. Most tellingly, if this “voluntary” approach was so effective, then why has virtually every country chosen a statutory approach for managing the seemingly far easier task of defaults on corporate debt?

Among the concerns are the following:

Delays - The collective approach can cause long delays in the debt resolution process. In the 1980s, some Latin America workouts took years to complete. It is extremely difficult to meet the needs of numerous cross-classes of debt holders.

Aggregation - Even the issue of determining who is a senior creditor is problematic. This is sometimes called the problem of aggregation. If there were a single class of creditors, it would be easy to define what one means by a majority of creditors; but if there are many classes, how is one to weigh the “votes” of junior and senior creditors?

Interest rates - Some debtors worry that such collective action clauses will increase the interest rates they will have to pay; some creditors worry that as a result, there will be less borrowing.


As a result of the problems with the U.S. Treasury collective action approach, most analysts agree that a statutory approach would be preferable, if there could be agreement about its design. But this appears unlikely; adopting bankruptcy laws within a country has often proved highly contentious, and there is every reason to believe an international agreement would be even more difficult.

Among the specific concerns over the IMF’s proposal are the following:

Arbiter - The IMF cannot act as a credible arbiter as it is one of the key interest parties; it is already a creditor controlled by other official creditors. The position of the dominant countries often seems dictated by the concerns of their financial markets, which in turn sometimes seem dominated by creditors. Critics argue this could easily create a perception of bias that would damage the legitimacy of the process. The IMF would decide when a standstill occurs and when it would end, whether the debtor is negotiating in good faith with its creditors, whether it is following sound polices and whether it can receive new financing. It would also fall to the IMF to pressure the private market to make concessions. Accordingly, there are some that suggest that there should be an independent International Bankruptcy Court, outside of the IMF.

Enforcement problems - There would be practical problems if an international bankruptcy court tried to force a country to meet its agreed obligations were that country to renege on an agreement. If a country defaults and creditors were to decide to accelerate repayment, creditors would have limited options. That’s because sovereigns have two basic assets outside their countries – international reserves and embassies. These are both exempt from attachment under sovereign immunity law. So the only way to enforce such seizure is to take it to the home country of the debtor and try to enforce it there – an onerous prospect. Enforcement would be easier if the bankruptcy process had broad “legitimacy,” which an IMF dominated process might not.

Chapter 11 vs. Chapter 9 - Of these two U.S. bankruptcy laws, some critics say Chapter 11 is less relevant then Chapter 9 which covers U.S. municipal and state defaults. Chapter 9 recognizes the primacy of the essential state functions of the public entity, such as social security, education and health. In other words, in satisfying creditors, the interests of other stakeholders not only have to be recognized, but, in many cases, given priority. Sovereign restructuring obviously entails far more complicated issues than are either addressed by Chapter 9 or Chapter 11, but these two chapters of the U.S. bankruptcy code provide intellectual frames. For instance, Chapter 9 might suggest that other stakeholders such as social security recipients would have priority over the IMF and the financial players who hold debt.

Stories about sovereign bankruptcies should answer as many of the following questions as possible:

  • How much external debt does the sovereign debtor have? How much interest is coming due?
  • What is the debt to GDP ratio? How does it compare to other countries with or without debt problems? What is the rate of debt service being paid to foreign creditors? Check to see how much this number has increased in recent years and what percent of the country’s GDP is being consumed by the debt burden.
  • Has the currency been devalued? Does a devaluation look likely?
  • How much income is the country generating from exports and what is it paying out in imports?
  • How did the debt originate? When were the country’s debts assumed? Was there, for instance, a particular period in time where the bulk of the debts were assumed?
  • What is the mix of the country’s debt? How much represents public external debt and what is the total that encompasses domestic, external, provincial and private debt?
  • Who are the major creditors - what countries have the greatest exposure? What percent of the creditors are in the private and public sectors? What banks are involved? Sometimes a few banks have very large exposures. One way of finding out is to check with international credit agencies.
  • Is the debt held by foreign entities or domestic ones? This is important, because a default may cause severe problems to the country’s financial system, as happened in Argentina. If domestic banks have loaned money to the government, will a default later require a bailout of those banks, too? What sorts of plans has the government made to deal with this kind of disruption? What would such a bailout do to the savings the government would get from the default?
  • What recourse do creditors have? Does the government own any assets overseas (other than embassies) that would be attractive to creditors?
  • How have other countries with such a crisis handled the crisis? How long has it lasted? How long has it taken them to regain access to international markets? As a country goes into a crisis, economic prospects often look bleak, but in some cases, recovery has occurred rapidly. Russia, for instance, had its first growth since the beginning of the transition after its crisis, and regained access to international capital markets within two years. There are controversies over the factors that contribute to a quick recovery: Mexico’s quick recovery is attributed to the growth of trade with the U.S. and the availability of credit from U.S. importers, more than to the IMF bailout. In the case of Russia, the post-crisis funds from the IMF simply went to repay the IMF, and thus played no role in reactivating the economy. You need to ask: what are the conditions that the IMF is imposing to provide funds? What will be done with the funds?
  • What steps are being taken for future crisis prevention? A criticism of the IMF’s current restructuring plan is that it doesn’t address crisis prevention, but given the frequency of crises in emerging markets, all such countries need to worry about whether they appear to be vulnerable.

Who to ask:

What are the rating agencies saying? Standard & Poor’s Corp. and Moody’s Investor Service, both U.S.-based rating agencies in New York City, issue ratings and commentary on the debt they rate. This includes the debt of many sovereign countries. What were the rating actions leading up to the country’s default?

Try to talk to local credit officials as they have the most hands-on understanding. But be careful: there is often a “party-line” the validity of which needs to be probed. Early stories blaming Argentina’s crisis on corruption or out-of-control provincial borrowing have been strongly questioned; most now believe that the fundamental problem was the exchange rate system; there would have been a crisis even if there were no corruption, and if provincial government had curtailed spending, some claim the crisis would have come even earlier.

Contact trade groups: EMTA is the principal trade group for the emerging markets trading and investment community and looks after investor rights and trading issues. It is based in New York City. This is a good source for gathering market statistics and commentary from the foreign investor perspective.

Banks: Call the major creditors in question and find out if they have named anyone to head up a restructuring team. However, this process can take many months after the initial default and it’s unusual for bank executives to talk publicly about such situations early on. Try local bank branches in the country that’s been affected. Also call investors, who are typically more willing to talk. Meanwhile make contact with the emerging market research teams of the big banks to gain additional information about the country’s restructuring prospects.

Make sure you talk to a variety of people from different groups. Remember that each party will have a different perspective. Scavenger funds, long term investors, banks and bond holders will often have different priorities and different views as to how the situation should be resolved.

Important Terms

Term Definition

a term coined by market participants and journalists referring to emergency loans made by G7 governments and/or international lending organizations to less developed countries to prevent currency devaluation, to avoid debt defaults, and to preclude the spread of economic ills to other countries.

Brady bonds

restructured bank loans that were extended to less developed countries in the 1970s and defaulted upon in the 1980s. The loans were restructured into bonds that are marketable and collateralized by US zero coupon bonds (definition below). The collateral takes the form of either a (rolling) guarantee on interest payments or a guarantee on principal.

Chapter 9 Bankruptcy Code

a court-supervised procedure in which municipal and state debtors are relieved from massive debt without having to liquidate their assets and distribute all the proceeds to creditors.

Chapter 11 Bankruptcy Code

a US federally sanctioned protection and reorganization plan, primarily for insolvent incorporated businesses, in which they are allowed to restructure their finances and continue operating as long as they work out payment plans with their creditors.

Collective Approach

the theory that the financial restructuring of bankrupt countries should be an informal process of negotiation among creditors conducted outside a legal system or without formal guidelines. The process is normally time consuming and involves the reluctant agreement of numerous cross-classes of debt holders.

Currency Board

a monetary authority acting in place of, or alongside, a central bank that issues money convertible into a foreign anchor currency or commodity at a fixed rate. The Board is precluded from issuing money except if backed by foreign reserves.

Debtor Country

a country that has been given financial assistance usually in the form of loans from other governments (bilateral assistance) or international lending organizations, such as the IMF or the World Bank (multilateral assistance). International financial assistance is used either for “balance of payment purposes” (e.g., to stabilize the country’s currency, bail out investors, or prevent the spread of economic hardship) or for specific “project” purposes (e.g., education, infrastructure, social safety net, etc.)


the failure to repay a loan’s or bond’s interest or principal payments.


occurs when a country's central bank decides to change the, until then, fixed value of the domestic currency. A depreciation occurs when the (already flexible) value of the national currency falls in value relative either to another currency or to a weighted average of a group of currencies. [The opposite of devaluation is revaluation. The opposite of depreciation is appreciation].

Drago Doctrine

formulated in 1902 by Luis Maria Drago, the Argentine foreign minister, maintained that European countries could not use military force to collect public debts from Latin American countries.

EMTA (Emerging Markets Trading Association)

the principal trade group for the emerging markets trading and investment community. Founded in 1990, it protects investor rights and decrees trading practices and norms .

Exchange Offer

allows a country or a company to reduce its existing debt obligations by replacing old debt with new debt that typically has more generous repayment terms.

Exit Consent

a formal agreement that allows a group of creditors to amend the non-financial terms of an old contract. Exit consents are used when the bonds do not have “collective action clauses” rendering a collective approach (see definition) to restructuring the bonds impossible. In this case, a majority of investors agree to change the non-financial terms of the bonds in a way that makes the bonds effectively worthless for the minority holdouts (see definition).

GDP (Gross Domestic Product)

the total value added of goods and services produced in one country in one year before the depreciation of previously produced capital is deducted.


individual creditors who refuse to partake in a debt restructuring effort already agreed by the majority of creditors. Holdouts prefer to take action, in some cases legal, to coerce the debtor to service the debt in full.

IMF (International Monetary Fund)

a special agency of the United Nations established in 1945 that loans money to member countries to help them relieve heavy debt burdens and stabilize their exchange rates. Today the IMF pursues a broad agenda of financial stability and assistance.


unpaid overdue interest or principal payments owed to public and commercial creditors.

International Bankruptcy Court

as an independent body, it would mediate disputes among creditors and their debtors, provide protection for countries with serious debt burden, legitimize the kind of bankruptcy processes that are available to individuals and business today, and provide a global forum for resolving issues of refinancing and default. Its creation is currently being debated among the countries and loan-making institutions of the world.

Majority Action Clause

as part of a debt contract, it enforces the decision by a supermajority of bondholders, say 75 percent, for the debt. The agreement is binding on the will of a minority and prevents them from delaying or otherwise disrupting the agreed upon financial terms, thereby adding predictability.

Moral Hazard

the tendency of debtors, once insured against some contingency, to promote just the kind of irresponsibility and waste they have protected themselves against.

Principal Payment

the amount of principal a country pays in foreign currency, goods, or services in a specified year.

Rogue Creditor

an individual creditor who does not cooperate with the terms of a loan that has been agreed upon by a broad group of debt holders. Instead, it holds out for its own interests. [Same as a “hold out creditor”].


is a legally binding measure that permits the debtor to stop servicing its debt while protecting it from the imposition of new (including legal) measures.

Statutory Approach

holds that some kind of formal legal framework or written code should guide the negotiations surrounding the reorganization of sovereign defaults.

The World Bank

also known as the International Bank for Reconstruction and Development, makes loans to less developed countries and private investors to encourage foreign investment. A division of the UN, it is run by a group of five international lenders, much of its assistance goes to public works projects.

World Trade Organization

mediates among countries to write and enforce rules on international trade and provides a forum for reducing trade barriers. Founded in 1995 as the successor to the General Agreement on Tariffs and Trade (GATT), the WTO is based in Geneva, Switzerland.

Zero Coupon Bonds

US government securities that do not pay interest during the life of the bond. They are bought at a discount but pay par at the maturity date. They can be quite volatile, and require that holders pay taxes each year on the interest as it accrues.

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