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Munich Personal RePEc Archive

The Next (but not new) Frontier for

Sovereign Default

Reinhart, Carmen

University of Maryland

April 2008

Online at

https://mpra.ub.uni-muenchen.de/11865/

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May 12, 2008

The Next (but not new) Frontier for Sovereign Default 1

Carmen M. Reinhart

University of Maryland and NBER

There is a view today that “this time it’s different” for emerging markets.

Governments are reducing their dependence on external debt and relying more on

domestic debt financing for the first time! Furthermore, emerging market governments

are increasingly issuing long-term domestic debt. Indeed, often this change in

government debt management patterns is taken as evidence of graduation from “serial

default.” In this new world, debt crises in emerging markets will be a thing of the past,

and the IMF is plainly out of business.2

Domestic debt is not a new invention

Yet, alas, apparently unknown to most observers in financial, academic, and

policy circles, domestic debt has been around for a quite a while. For that matter, so too

has been default on domestic debt of one form or another. In our latest paper, Kenneth

Rogoff and I unearth a vast trove of historical time series data on external and domestic

public debt for 64 countries ranging back to 1914. Our key sources are publications of

the now-defunct League of Nations, updates by its successor, the United Nations, and the

work of many scholars and government agencies.

1

This article is based on Carmen M. Reinhart and Kenneth S. Rogoff’s (2008) “The Forgotten History of Domestic Debt.” NBER Working Paper 13946, April (2008).

2

Carmen M. Reinhart, Kenneth S. Rogoff, and Miguel A. Savastano (2003). “Debt Intolerance,” Brookings Papers on Economic Activity, Spring, 1–74, document cases of “serial default,” that is cases where

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Although it may come as quite a surprise to most readers that historical time

series on domestic debt should be exotic for so many countries, it is. This is in contrast to

external sovereign debt, on which there is a vast literature. We are not aware of any

academic or policy study that uses similar data, certainly not one encompassing such a

long time period and so many countries.

Indeed, historical data on domestic (internal) government debt has been ignored

for so long that many observers have come to believe that the recent rise in domestic debt

in many emerging markets is novel. This perspective is based on the belief that,

historically, domestic government debt played only a minor role in the public finances of

most developing countries. The new data thoroughly dispels this notion. The key

findings of Reinhart and Rogoff (2008) are summarized in the remainder of this article.

First, domestic debt is and was large—for the 64 countries for which we have

long time series, domestic debt averages almost two-thirds of total public debt; the

increase in the share of domestic debt in the last few years is but an upward “blip” in the

larger context. For most of the sample, these debts typically carried a market interest

rate, except for the era of financial repression after World War II. From 1914 through

the 1960s, before inflation became a widespread phenomenon, more than one-half of

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[image:4.612.96.493.111.328.2]

Figure 1

Domestic Public Debt as a Share of Total Debt, 1900-2006

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Sh

ar

e

of which North America

All countries

of which Latin America

The puzzle of “debt intolerance”

Recognizing the significance of domestic debt goes a long way toward

explaining the puzzle of why many countries default on (or restructure) their external

debts at seemingly low debt thresholds. In fact, when heretofore ignored domestic debt

obligations are taken into account (as shown in Figure 2), fiscal duress at the time of

default is often revealed to be considerably more severe.3 Specifically, debt-to-revenue

ratios are about twice as high for total (domestic plus external) debt as the standard ratios

that only considered external indebtedness.

3

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Default through inflation

Domestic debt may also explain the paradox of why some governments seem to

choose inflation rates far above any level that might be rationalized by seignorage

revenues levered off the monetary base. (This was the puzzle first pointed out in Cagan’s

classic, 1956, article on post-war hyperinflations.)4 Although domestic debt is largely

ignored in the vast empirical literature on high and hyper-inflation, we find that there are

many cases where the hidden overhang of domestic public debt was at least the same

order of magnitude as base money, and more often than not, a large multiple, as shown in

Figure 3..

4

[image:5.612.98.512.125.408.2]

Cagan, Philip (1956). “The Money Dynamics of Hyperinflation.” In Milton Friedman (ed.), Studies in the Quantity Theory of Money. Chicago: University of Chicago Press.

Figure 2. Public Debt-to-Revenue Ratios During External

Default: 89 Episodes, 1827-2003

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00

Africa Asia Europe Latin America Ratio

Total Debt

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[image:6.612.102.523.171.444.2]

Figure 3

Domestic Debt and Monetary Base During High Inflation

0 50 100 150 200 250 300 Argentina, 1989 Brazil, 1990 Germany, 1920 Greece, 1923 Italy, 1920 Japan, 1945 Norway, 1920 Philippines, 1984 Turkey, 1994 A s a P er cent of G D Domestic debt/GDP Base money/GDP

Outright defaults on domestic debt

Where there are domestic debts there is also domestic default. Our paper offers

a first attempt to catalogue episodes of outright defaults on and reschedulings of domestic

public debt across more than a century. This phenomenon appears to be somewhat rarer

than external default, but far too common to justify the extreme assumption that

governments always honor the nominal face value of domestic debt. When outright

default on domestic debt does occur, it appears to occur under situations of greater

duress than for pure external defaults—both in terms of an implosion of output and

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external debt, the economy is stagnant or in recession (on average, real per capita GDP

edges down slightly from its level four years before the crisis); on the eve of domestic

default, however, the output contraction is much deeper, as GDP registers an average

decline of about 8 percent.

It is important to note that we do not here catalogue episodes of major de facto

partial defaults, say through a sharp unexpected increase in financial repression (e.g., of

[image:7.612.160.474.298.561.2]

the type China still imposes today).

Figure 4

Domestic and ex ternal crises

Level of real GDP, index t-4=100

90 92 94 96 98 100 102 104

Four years before

Three years before

Two years before

One year before

Year of crisis

One year after

Two years after

Three years after

Domestic

External

Reflections on future prospects

Celebration about graduating from a history of serial default may be premature. This

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contingent debt contracts (for example, see those discussed by Guimaraes) will

significantly lessen the likelihood of sovereign default or restructuring. 5 One variety of a

state-contingent contract is inflation-indexed debt. At the time of this writing, Argentina

is engineering a partial default on its domestic debt by significantly understating the

domestic inflation rate (reported at about 8 percent) to which the debt is indexed.

Unofficial estimates of inflation are in the order of 25 to 30 percent.6

Governments that have repeatedly defaulted on their external debts, inflated away

or outright defaulted their domestic debts, will, in all likelihood, not hesitate to default

again.

5

See Bernardo Guimaraes “Emerging economies’ debt contingent on world real interest rates,” VoxEU October 8, 2007.

6

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