Existing work, and my contribution

Why have previous attempts to explain government borrowing from BRICs been unsuc-cessful? The following discussion of existing literature will focus on the underlying reasons in order to inform my own theory. To do so most effectively, I will analyze existing work first with respect to the outcome to be explained, and then with respect to the explanations put forward to explain the outcome.

2.2.1 The outcome to be explained

One characteristic of developing countries is the lack of sufficient capital and the subse-quent need to import it. To obtain capital, the governments of developing countries can choose from several different sources of credit. However, existing literature only focuses on the determinants that explain why governments borrow from a specific creditor in iso-lation. Thus, we know when developing countries borrow from the IMF (Vreeland, 2007;

Copelovitch, 2010b) or the private market (Tomz, 2007). However, these works ignore the fact that developing countries have to choose between several creditors: Multilateral or-ganizations such as the IMF and the World Bank, bilateral loans from western countries, bilateral loans from BRIC countries, and private creditors.

What is interesting, though, is that the total amount of debt they can obtain is limited.

Just as is the case for private individuals in search for financing to purchase a house, a reverse budget constraint exists for governments: creditors will not extend loans if the country’s sustainable level of debt has been reached. That is, once the amount of debt is larger than the capacity of debtor to ‘carry’ this debt (as measured by their economic strength), no creditor will extend additional loans, as they fear that this debt will either not be serviced or will be defaulted on. Given such a limit of the total amount of debt that can be obtained, a government’s decision for one creditor is also a decision against another.

From a borrower’s perspective, a maximum debt ceiling introduces an interdependency between the various sources of credit. It is therefore essential to explain the choice between

creditors instead of only analyzing the determinants of whether a government will borrow from a specific creditor or not.

I therefore argue that political economists should focus on the choice between sources of credit instead of analyzing the determinants of borrowing from a specific creditor in isolation. Such an approach is necessary to explain why some countries borrow from BRICs instead of the IMF and vice versa – or why some countries decide to borrow a bit from both creditors.

The borrower’s choice of lender manifests itself in the resulting debt composition.

Economists have pursued the analysis of debt composition both in the private and the public realm. For example, starting with the seminal article by Modigliani and Miller (1958), a vibrant literature studies the determinants of private firms’ debt portfolios.

However, with respect to sovereign debt, the literature is limited. Differences in the aggregated value of assets and liabilities denominated in foreign currency have been found to be a cause for variation of countries’ vulnerability to financial crisis (Eichengreen, Haus-mann and Panizza, 2003). Subsequent research on the reasons for the inability of countries to issue bonds denominated in their own local currency gained significant attention. The so-called ‘original sin’ increases the risk of financial crises, as a real exchange rate depreci-ation would make it more difficult to service debt if it is denominated in foreign currency (Eichengreen, Hausmann and Panizza, 2004; Melecky, 2012). Scholars working on the issue of ‘debt intolerance,’ in turn, have attributed this inability to borrow in local currency to weak institutions and bad policies in emerging economies (Reinhart, Rogoff and Savastano, 2003)¹ .

However, these approaches have only looked at the composition of sovereign bond port-folios. Bonds represent only a subset of financing options, the others being syndicated loans as well as multilateral and bilateral loans. Consequently, the interdependencies between

1 A parallel body of work has examined differences in maturity structures of debt portfolios as shorter maturities require more frequent rollover of debt, and therefore result in higher volatility (Chamon et al., 2005)

multilateral and bilateral loans as well as bonds are not taken into account. In addition, the portfolios have been analyzed with respect to currency denomination and maturities of the bonds, but not to the identity of the creditor. In other words, Chinese money is considered to be identical to American money, as long as it is denominated in the same currency. However, existing scholarship (for example Woo, 1991, p.158) finds that the identity of the creditor matters even if the financing terms are identical.

In sum, the existing literature on sovereign debt misspecifies the outcome that is to be explained. To address this, I will focus on the choice between creditors instead of explaining the choice for a specific creditor.

2.2.2 The explanations proposed

What explains the distribution of loans between sovereign creditors and debtors? The existing literature focuses primarily on the decision calculus of the creditors to explain the flows of sovereign credit.

For example, scholars analyzing which countries receive IMF loans primarily focus on the supply side. Thacker (1999) and Stone (2004) contend that the IMF is merely an instrument of the US, and lending behavior consequently mirrors the interests of its largest shareholder. More refined analyses have taken private interest groups within the industrialized countries into account. For example, Copelovitch (2010a,b) argues that IMF lending follows the interests of the domestic financial sector in the United States, Japan, Germany, the United Kingdom, and France. The IMF lends more money to developing countries to which private banks of G5 countries are highly exposed, as this reduces the risk of a default. In this view, the IMF loans provide a bailout to the private sector actors of its major shareholders. In sum, therefore, IMF lending is explained from a creditors’

perspective.

The analysis of which governments obtain debt from private creditors is similarly one-sided. In his influential book, Tomz (2007) argues sovereign debtors are at the mercy

of international private creditors. As only the creditors judge the developing countries’

credit worthiness, they alone determine who obtains private capital. Tomz conceptualizes the recipient countries as sovereigns with only one desire: implement policies that please private creditors so as to regain or maintain their creditworthiness.

The examples of existing literature cited above suffer from the fact that they explain the presence of loan agreements solely with the actions of creditors. Debtor countries are typically viewed as a reactionary partner that merely needs resources, regardless of the source. Developing countries are therefore conceptualized as actors without agency.

There are some exceptions that utilize a debtor perspective to explain borrowing deci-sions. For example, scholars have argued that a government might obtain IMF loans not for the monetary resources. Considering that the conditions attached to IMF loans are costly, governments hope that an IMF program is a “seal of approval” as a signal to po-tential investors (Aggarwal, 1996; Marchesi, 2003). However, while the recipient has been conceptualized as an active player, these analyses understood debtors only as a single, ho-mogenous entity. For example, Obstfeld and Rogoff (1996, p.350) state that “throughout our analysis, we will treat each sovereign borrower as a single unified entity, ‘the country.”’

When explaining IMF lending from a borrower’s perspective, other scholars suggest that the IMF conditions provide the recipient government with leverage to implement unpopular economic reforms – such as devaluations or austerity measures – against domestic resistance (Remmer, 1986; Edwards and Santaella, 1993; Vreeland, 2003b). For example, Putnam (1988, p.457) states that “international negotiations sometimes enable government leaders to do what they privately wish to do, but are powerless to do domestically ... this pattern characterizes many stabilization programs that are (misleadingly) said to be ‘imposed’

by the IMF.” However, while this line of work acknowledges that there may be domestic interests that are against borrowing from the IMF, these actors are not explicitly analyzed.

We do not know who they are, why they oppose the conditions attached to IMF loans, nor what they want instead. We only know of the presence of ‘domestic resistance’ that

provides incentives to the government to seek an external ally.²

However, extensive literature on a related topic makes a strong case that this assump-tion is outdated. Works on the political economy of trade (see Rogowski (1989); Grossman and Helpman (1994); Scheve and Slaughter (2001); Hiscox (2002); Baker (2003)) incorpo-rate insights by the Heckscher-Ohlin and Stolper-Samuelson theorems that suggest various actors are affected differently by international flows of trade: some benefit from increased trade because of their position in the domestic economy, while others lose out. Consider-ing these distributional consequences these domestic interest groups have an incentive to lobby their governments. Disaggregating the analysis to examine the effect of domestic interest groups therefore helps to explain government policy decisions. I argue that the political dynamics between domestic interest groups within developing countries are the key to explaining why a government obtains a loan from one source versus another.

2.2.3 Requirements for satisfactory explanation

The analysis presented above reveals gaps in the existing literature that are responsible for the inability to explain the observed patterns of sovereign borrowing. A satisfactory explanation must therefore address three issues: First, the outcome to be explained must be the choice between creditors as opposed to the choice whether or not to borrow from a single creditor. After all, developing countries have several sources of credit available and yet are constrained by an upper limit of total debt that can be obtained, which introduces

2 Analysis of the effect of competing domestic interest groups has been used to explain questions related to the IMF. For example, Nooruddin and Simmons (2006) argue that domestic interest groups matter for the distributional consequences of IMF agreements. If the IMF demands spending cuts, it initially does not specify which part of the budget should be reduced. As the eventual budget cuts are a result of negotiations between the IMF and the government, Nooruddin and Simmons argue that there is space for domestic interest groups to influence where the cuts are to be made. They show that in democracies it is the poor that are typically the losers as they are usually not as organized. As they consequently lack political voice they are harder hit by spending cuts (See also Woo (2010) and Conway (2006)). However, these approaches assume that an IMF agreement has already been reached, and domestic politics only factors into the secondary decision regarding how to subsequently distribute the consequences amongst domestic constituencies. I argue that this makes the second step before the first, as no consideration is given to how the same domestic coalitions might affect the decision to seek out an IMF agreement in the first place.

an interdependency between obtaining debt from one source versus another. Second, under these conditions, an explanation of borrowing patterns cannot be provided from a creditor perspective. Instead, the decision calculus of the recipient country must be at the center stage. It is therefore necessary to examine the incentives faced by the recipient government.

In particular, a satisfactory theory must incorporate the preferences of domestic actors to which the government responds. The political dynamics of competing domestic interest groups might drive the government’s borrowing strategy. Third, if the government’s choice between creditors is to be explained with the preferences of various domestic actors, an approach must start by analyzing the distributional consequences for each actor across each type of loan.

Following the considerations laid out above, I begin by defining the domestic actors Finance, Industry, and Labor. I then introduce the various borrowing options available to the central government and analyze the distributional consequences that each type of loan would have on the three domestic actors. The subsequent analysis of coalitional dynamics results in an explanation regarding when a government has the incentive to borrow from emerging lenders as opposed to traditional lenders.