The Strained Marriage of Public Debts and Private Contracts

January 2, 2018

As a new year begins, governments around the world are poised for another cycle of debt disputes and missed payments. Venezuela is stumbling into default after starving its people for years to pay foreign creditors. Its hard currency reserves are drying up under pressure from US sanctions as the government battles hyperinflation, runs out of things to sell to China and Russia, and tries to buy time with a wacky virtual currency scheme.

Meanwhile, Ukraine and Puerto Rico will each go to court in January to fend off debt collectors. Ukraine has appealed an English court decision that would enforce its debt to Russia as if it were an ordinary commercial contract, despite Russia's annexation of Crimea, crippling trade sanctions, and sponsorship of separatist conflict in eastern Ukraine. A fund known for making a fortune from suing Argentina has challenged a US federal law enacted in 2016 that promised bankruptcystyle debt relief for Puerto Rico. If the fund wins, hopes for a fresh start for the hurricane-battered commonwealth and an equitable resolution for its creditors would dim.

On the bright side, Greece plans to exit the multilateral lending programs that many of its citizens had come to associate with economic collapse, austerity, and loss of policy autonomy. It aims to return to the private financial markets in the fall of 2018. Looming in the background is its debt to euro area governments, which will take generations to repay.

Each of these crises is intensely political, even constitutional, but politics is barely visible in today's sovereign debt restructuring regime. This informal regime coalesced in the 1980s and 1990s around a relatively stable transatlantic core of governments, international organizations, and private creditor groups, and depended on coordination among them. Throughout this period, private capital flows grew in size and importance to sovereign finance. In response, debt contract reform moved to the forefront of the policy agenda, and quietly took over.

Private contracts are the foundation of private capital movements. The catch phrases "freedom of contract" and "sanctity of contract" capture the ideal: debtors and creditors freely agree on the terms of their relationship up front, and must abide by this private constitution in good times and bad. Domestic courts step in only to resolve disputes.

When governments borrow in the private financial markets, they enter into private debt contracts. These contracts are highly standardized, which makes them easy to trade. In a world where governments borrow primarily from the private markets, changing contracts is an appealing way to deal with sovereign debt crises. The trouble is, governments are very different from private debtors. Trying to solve public debt problems by changing private contracts is at best inadequate. At worst, it can backfire and complicate crisis response.