In all of the drama of the financial meltdown over the past eighteen months or so, one segment of the global market has been relatively immune: sovereign debt (borrowing by nations). Indeed, relative to the rest of the market, the sovereign markets have thrived. As the domestic banking and corporate sectors of many nations have floundered, these countries have used their sovereign borrowing capacity to borrow and then bail out their weakened private sectors. As for those nations that found themselves in trouble (as was the case in a number of Eastern European countries), the IMF was there, ready and eager to hand out funds.
In hindsight, it is perhaps obvious that this state of affairs was not sustainable. At some point, sovereign borrowing inevitably reaches a level at which repayment becomes difficult (especially when the private sector bailouts don’t work). That point was perhaps reached roughly a month ago when Dubai had a default (it was corporate debt, but of a corporate entity where the government was a major holder). That produced concerns about the viability of other nations and the ratings downgrades of the debt of other nations (Greece being the most prominent).
All of this has produced much concern about whether the world is on the brink of another major financial crisis, this time with sovereigns. And if the sovereigns default, there is no one to bail them out (except perhaps the IMF, but it does not have limitless funds).
Likewise, David Zarig observes:
Sovereign debt defaults look like they will be the next part of the financial crisis, unless you believe that sovereigns are much more constrained now than there were during the 1980s. I'm sympathetic to the constraint view, but I make no claims about debt load analysis, and I am, after all, a lawyer. Anyway, if I'm right, it will be a triumph of international law and international institutions (particularly the World Bank and IMF). If I'm wrong (and many macroeconomists would bet against me), then it will be bad news, etc
My bet is that the news will be bad. Why? As Gulati explains:
This time, it is not the usual suspects such as Brazil and Mexico who are in the worst positions. Instead, it is the industrialized nations who have borrowed so very heavily to fund their bailouts.
Imagine a scenario in which, say, Greece defaults. Then there are ripple effects throughout the euro-zone, bringing down the rest of the so-called PIGS nations--Spain, Portugal, and Ireland. After which, comes the deluge.
I'm not an international law guy, but I used to play one on TV. Specifically, I wrote Comity and Sovereign Debt Litigation: A Bankruptcy Analogy:
On repeated occasions in the post-war period, the cumulative effects of policy mistakes, recessions, inflation, and other economic problems have made it difficult for sovereign debtors to service their external debt. Unlike a domestic U.S. private debtor, who may resort to formal bankruptcy procedures in the event of insolvency, a defaulting sovereign debtor has no formal mechanism for triggering a restructuring of its debt.It's a little outdated in places (okay, a lot), but it's also timeless (IMHO).
In some cases, sovereign debtors have resorted to a moratorium on debt payments. This article argues that U.S. courts ought to give effect to such moratoria under the international law principle of comity. Using standard game theory methodology (the so-called "creditors dilemma" variant of the famous "prisoners dilemma"), the article argues that creditors of such debtors would agree in advance to give effect to such a moratorium provided it neither repudiated the sovereign's debts not gave preference to certain creditors. A legal test for granting comity to sovereign debt moratoria is therefore proposed.
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