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In the wave of sovereign debt crises during the 1980s, government decisions to default appear roughly related to global real interest rates. As the Federal Reserve raised interest rates steeply to combat entrenched inflation, a rash of sovereign defaults followed in developing countries, starting with Mexico in 1982.
At the peak in 1985, 25 governments were in external default.
Discussion of these events tends to lean on an intuitive, first-order explanation: As rates rise, sovereign debt becomes more expensive to service (when interest rates are floating) or to roll over into new loans. But high interest rates also drive the decision to default through another, even more potent mechanism, according to findings by Minneapolis Fed Senior Research Economist Juan Pablo Nicolini and Bank consultant Timothy Kehoe: High rates increase expectations of a better deal for the debtor after default. (See Working Paper 806, “Default and Interest Rate Shocks: Renegotiation Matters” with Victor Almeida and Carlos Esquivel.)
The intuition for this finding goes to the incentives of creditors. When the real, risk-free interest rate is higher, creditors holding delinquent debt could be earning higher returns on whatever portion of that investment they could recoup. (When interest rates go up, so does the opportunity cost of holding bad debt.) Creditors are therefore inclined to take a larger “haircut” (offer lower rates when renegotiating the debt). A debtor government, which anticipates these more favorable terms in the event of default, finds default more attractive and is more inclined to do so.
The economists innovate upon the extensive sovereign debt literature by modeling the decision to default and the bargaining process that follows, in which the haircut is determined within the model. They calibrate the model to match Mexico at the time of its sovereign default in 1982, and the conditions of its later reentry to global credit markets.
The model reveals a substantial role for this “renegotiation mechanism,” versus the standard explanation that higher rates simply make borrowing more expensive. The economists determine that the renegotiation mechanism accounts for about half of the risk of government default. Default is about twice as likely when the haircut is determined by bargaining inside the model versus a fixed haircut set exogenously. Default is four times more likely than when there is no possible haircut.
In a corroborating exercise, the economists assess the empirical relationship between interest rates and debt haircuts. They analyze all restructurings that followed sovereign defaults between 1999 and 2020 and estimate that a 1 percentage point increase in the real risk-free interest rate (the 1-year Treasury bill rate, minus inflation) is associated with a 6 to 7 percentage point increase in the haircut, on average.
Many factors, including luck, affect the path of a country facing a debt crisis. Even within the simplified world of the model, the terms and timing of reentry to credit markets are subject to wide variation. But the economists must contend with the especially challenging example of Mexico, which did not gain access to international credit again until 1990—eight years after its default. Other Latin American countries defaulting in the 1980s took even longer. These extended periods of exile fit awkwardly, at first blush, with the notion of a strong renegotiation motive.
The economists argue that unexpected actions by U.S. bank regulators caused a much longer delay than Mexican officials likely expected. Based upon the experiences of sovereign defaults in the 1970s, Mexico might have expected a chance to renegotiate and reenter credit markets once every two years. But the chain of defaults sparked by Mexico in 1982 revealed the collective overexposure of U.S. financial firms to Latin American debt. To protect the safety and soundness of U.S. banks, regulators forbade them from making swift deals to renegotiate the debts of Latin American governments, for fear the accumulated write-downs would set off a U.S. banking crisis.
The result was a long delay and harder bargain than Latin American countries might have expected (and certainly less than they had hoped). By this logic, the renegotiation motive was strong indeed, inclining governments toward a default decision that looks less wise with the benefit of hindsight.
Read the Minneapolis Fed working paper: Default and Interest Rate Shocks: Renegotiation Matters
Jeff Horwich is the senior economics writer for the Minneapolis Fed. He has been an economic journalist with public radio, commissioned examiner for the Consumer Financial Protection Bureau, and director of policy and communications for the Minneapolis Public Housing Authority. He received his master’s degree in applied economics from the University of Minnesota.
