The Big Change in Sovereign Debt Politics No One’s Talking About…

So a few days ago there was an interesting story going around that hedge funds were going to try to sue Greece if the sovereign tried to force its creditors to take a loss. Now this was two or three news cycles ago and the story has since moved on (there was talk a deal was complete, then new talk that a deal was hung up on interest rates, then they were going to be kicking off a new round of negotiations, and I’ve since lost track…), but I want to go back to this hypothetical because it’s crazy for a number of reasons.

The first is simply the usual hypocrisy you hear whenever a creditor who has been earning outsized returns because they were taking on risk turn around and, ex post after the risk has been realized, are completely outraged about losing out on their investment. Look, the reason Greek debt always paid higher returns than risk-free German or US debt (side note: is there any risk-free asset in the world today?) is because Greek debt was never risk free. This is a pretty basic “there’s no free lunch” principle of investing, but it always surprises me how rarely it comes up in these kinds of discussions. Everyone is shocked, just shocked when someone who had a pretty good chance of defaulting actually defaults – it’s ridiculous.

There’s something extra interesting about this case though, which first requires a bit of background on international relations theory. Unlike at the national level, at the international level there is no supreme authority to enforce rules, ie the global system is ruled by anarchy. For sovereign debt, what this means is that if a country is considering defaulting on its debt to foreign creditors, there isn’t any authority that can force it not to. So why don’t countries default all the time? Because if they did they’d develop a reputation as defaulters (*cough, Argentina, cough*) and the next time they wanted to borrow money they’d find it extremely expensive, if not altogether impossible. So a rational state, knowing that it will want to borrow money in the future at reasonable rates, has an incentive to not anger creditors today, which serves as an enforcement mechanism for repaying sovereign debt.

But note that this mechanism depends on the negative reputation effects of not honouring a debt contract. If a claim on a country is viewed as widely illegitimate or unfair – say, for example, when greedy hedge funds buy up cheap distressed debt and then demand full payment – it seems reasonable that future creditors won’t judge this as harshly as if, say, tomorrow Germany announced it wasn’t going to pay back any of its debts. So when a state is internally debating whether or not to pay back debt, it weighs the legitimacy (in the sense of whether other market actors think the debt should be paid back) of the outstanding debt; as legitimacy falls, the marginal effect of defaulting on the debt on future borrowing ability falls, and so the inclination to default increases.

Now to the interesting part in this case: the hedge funds are essentially trying to get around this anarchy problem by threatening to take Greece to the European Court of Human Rights. Specifically, they’re claiming that changing the terms of Greek bonds would be a property rights violation, and according to European law property rights are human rights. Somewhat remarkably to me, the NYT article suggests this actually could be a successful legal strategy. I don’t know enough (read: anything) about European law to fully understand what kind of power this court holds over Greece; presumably this can’t fully get over the anarchy problem as I doubt the court can deploy soldiers to Greece and/or throw the government in jail, but I assume they have some sort of power to impose costs of some kind, rather than just making proclamations. So if the hedge funds won at court, Greece would have to choose between paying them or suffering the costs of being in violation of the court, a fact which should alter the government’s current calculation of whether to default. Which is a pretty big qualitative change in the international relations of sovereign debt. Did European states know this was what they were signing up for in creating the EU? (I don’t mean that in a rhetorical way to suggest it was a mistake, it’s an honest question – I don’t think the full ramifications of semi-sovereignty have yet been fully realized…)

A final funny point to consider is that everyone knows the hedge funds would happily accept a deal where they get paid 60 or 70 cents on the dollar of the debt they currently hold (the last figure being debated was 50 cents, with the Greeks (read: Germans and IMF) wanting to push it lower.) But, again with the caveat that I have no legal background, it seems to me like it’d be pretty hard to make the case that a cut of 30 cents on the dollar is legal but a cut of 60 cents on the dollar is illegal. Presumably the legal argument has to be built around sticking to the exact letter of the bonds, even though this is something that no investor/policymaker currently takes at face value…

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