Ecuador's Shenanigans

Below is a guest post from Mitu Gulati (Duke, law):

In the wake of the recent drama in the sovereign debt world in Greece, Dubai, Iceland and elsewhere, memories of the shenanigans that went on with the recent Ecuadorian debt restructuring have faded.  The Ecuadorian government was in the fairly unique situation of having the funds to pay, but being unwilling to do so.  Their purported rationale:  An audit committee whose members the government had handpicked (including a number of prominent anti debt activists) had decided that some of Ecuador’s past debts were “illegitimate”.  It is not quite clear what Ecuador meant by the term illegitimate, but it is a good guess that they were trying to invoke the legal doctrine of Odiousness.  Under customary international law, arguably, the debts of a past government do not need to be repaid when those debts were used for purposes adverse to those of the population (and this was done with the knowledge of the creditors).  It would be an understatement to say that the foundations of this doctrine are shaky as a matter of international law, let alone whether a domestic court (the debt in question that Ecuador was complaining about was governed by New York law) would incorporate it.  Interesting though it is, I’m less interested in the international law aspects of what Ecuador did, however, than the international relations aspects (Adam Feibelman of Tulane Law, however, has an interesting piece on this that is coming out soon).  Specifically, what is intriguing about the Ecuador case is that it goes against the conventional wisdom that sovereigns rarely default when they are able to pay because they want to preserve their ability to borrow in the future (the “reputational” model of sovereign borrowing).  The Ecuadorian government, however, decided that its current political needs (there was strong domestic support for a repudiation of debts and an election was in the offing) outweighed its future borrowing needs (when perhaps a different government would be in power anyway).  Most interesting, the Ecuadorian government must have made the calculation that the reputational costs would not be large.

There are other costs that can accrue to a misbehaving sovereign debtor though.  Specifically, the multilateral international institutions like the IMF, the World Bank, the Inter American Development Bank and so on, can get miffed, particularly if they think that the misbehavior in question imposes negative externalities on the financial system.  And if they are miffed, that cuts off the sovereign debtor’s source of emergency financing.  In Ecuador’s case, however, there was nary a peep of disapproval from the multilaterals.  Why not?   

In an article just posted on SSRN, economist Arturo Porzecanski (American University) skewers not only the behavior of the Ecuadorian government but also that of the multilateral lenders who behaved like sheep in the wake of what happened.  Apart from being one of the smartest minds in the international finance business and one of the gurus of emerging markets financing, Arturo writes with great style and his piece is well worth reading – plus, he says what he thinks, unlike many others.  The piece is titled “When Bad Things Happen to Good Sovereign Debt Contracts: The Case of Ecuador” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1557040)

Felix Salmon, another delightful writer, who is by far the most knowledgeable reporter on sovereign debt/emerging market issues, has also had some wonderful pieces on this. My favorite is titled “Ecuador’s Idiotic Default”  (http://www.portfolio.com/views/blogs/market-movers/2008/12/12/ecuadors-idiotic-default/) (but I do have to ask Felix:  Over a year later, does Felix still think it was idiotic?  I thought it was at the time.  But today, in hindsight?) 

There was other sheep-like behavior, such as on the part of the trustee in this case.  Lee Buchheit and I explore this in a related article, “The Coroner’s Inquest.”    

At the end of the day, the question is whether Ecuador will suffer a reputational penalty for its behavior in the longer run (that is, when it needs to go to the private lending markets for its next bond issue).  I confess that I’ve never had much faith in the ability or willingness of the multilaterals to act appropriately; they are, after all, political animals.  Ecuador might well have made the smart calculation that the reputational costs simply would not be that high.  After all, Greece, for all its “book cooking” seems to be borrowing more.

--Mitu Gulati

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Sovereign defaults are becoming a popular topic here at the Lounge, it seems.  Here are some prior related posts:

The Greek Crisis: Economic Meltdown or Mental One?
The Modern Greek Drama: Comedy, Tragedy, or Both?  

The Modern Greek Drama, Part 2 

Verge of the Unböring (The Modern Greek Drama, Part 3)

Is 2010 The Year of Odious Sovereign Defaults?