Because markets work to protect the value of their assets, not only do market-based
sovereign debt swaps not avert macroeconomic crises (like those in Russia in 1998 and
Argentina in 2001), they might even accelerate them. This is the main finding of new
research by Professors Joshua Aizenman and Kenneth Kletzer and Dr Brian Pinto,
published in the Economic Journal. Their story is built on three arguments:
• If, for example, interest rates on rouble debt are much higher than those on dollar
debt, this must be because rouble debt is subject to higher risk from devaluation.
• The government has to find some way of living within its budget constraint. If debt is
very high relative to taxes, the government might be forced to devalue as a way of
lowering the burden of rouble debt; by definition, dollar debt will not be affected.
• If, in such circumstances, the government switches out of rouble debt and into
dollars, it will be forced to raise the rate of devaluation: if there is less rouble debt,
the rate at which it is taxed (the devaluation) might actually go up. This could then
persuade rouble debt holders to exit, forcing a crisis.
An unsettlingly clear implication of the analysis in this study is that there may be very few
options left once public debt reaches levels regarded as unserviceable under prevailing
fiscal fundamentals. If a big fraction of debt is in dollars, this only makes matters worse, and
could force a default.
The research studied both the Russian and Argentine debt swaps. The seemingly
unassailable logic behind the Russian swap from rouble treasury bills to dollar eurobonds in
July 1998, a month before the country’s economic meltdown, was that the government
could lower its interest payments and frees itself from the mercy of a whimsical market. The
swap was hailed by market analysts as ‘The Great Rouble/Dollar Debt Swap’ and as the
‘most positive aspect of the program’.
Similarly, David Mulford, international chairman at Credit Suisse First Boston, was cited in
the Financial Times as describing the June 2001 Argentine debt swap, which sought to
lengthen debt maturities, as a new, market-led solution to sovereign debt crises that other
governments would be watching.
But the debt swaps saved neither Russia nor Argentina from spectacular economic crises.
During a post-mortem of the 1998 Russian crisis, then first deputy managing director of the
International Monetary Fund (IMF), Stanley Fischer, expressed scepticism that a ‘marketfriendly
restructuring alone can fundamentally change a country’s debt dynamics. Such
restructurings take place at market prices, and thus almost by definition, do not significantly
change the present value of the country’s debt obligations….’.
And Lesson 8 of the ten lessons distilled by the Independent Evaluation Office (IEO) in its
July 2004 evaluation of the IMF's role in Argentina noted: ‘Financial engineering in the form
of voluntary, market-based debt restructuring is costly and unlikely to improve debt
sustainability if it is undertaken under crisis conditions and without a credible,
comprehensive economic strategy. Only a form of debt restructuring that leads to a
reduction of the NPV of debt payments or, if the debt is believed to be sustainable, a large
financing package by the official sector have a chance to reverse unfavorable debt
dynamics’.
These sobering assessments stand in marked contrast to the euphoria that greeted the
Russian and Argentine debt swaps. In retrospect, the idea that the swaps could ‘solve’ the
Russian and Argentine crises were hopelessly optimistic. This is because markets work to
protect the value of their assets - precisely why both Mr Fischer and the IEO noted that for
debt swaps to work, they have to reduce the debt burden of countries. But if this happens,
the creditors lose, and they will not let this happen in a voluntary debt swap.
ENDS
Notes for editors: ‘Sargent-Wallace meets Krugman-Flood-Garber, or: Why Sovereign
Debt Swaps Don’t Avert Macroeconomic Crises’ by Joshua Aizenman, Kenneth Kletzer and
Brian Pinto is published in the April 2005 Economic Journal.
Joshua Aizenman and Kenneth Kletzer are Professors of Economics at University of
California, Santa Cruz; Brian Pinto is at Centre for Social and Economic Research,
Warsaw.
For further information: contact Joshua Aizenman on +1-831-459-4791 (email:
jaizen@ucsc.edu, website: http://econ.ucsc.edu/faculty/jaizen/); or RES Media Consultant
Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email:
romesh@compuserve.com).