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For government borrowers, sovereign debt comes broadly in two flavors. “Private debt” can take the form of bonds sold directly to investors, or loans from banks and other commercial lenders. “Official debt” refers to financing from other governments, as bilateral loans or loans from multilateral organizations, such as the World Bank and International Monetary Fund (IMF).
Over the past century, governments in developing economies have relied on a mix of official debt and private loans from foreign lenders. Theoretical models of sovereign default have nonetheless treated all sovereign debt the same, with qualities that resemble private debt: Loans are presumed to be of short duration, especially for countries considered at risk of default. The consequence of defaulting is an abrupt loss of access to credit markets. Additionally, sovereign default has often been modeled as a binary event—an all-or-nothing choice, reflecting private creditors’ usual reluctance to offer concessions.
These assumptions have figured in influential work by Cristina Arellano, a Minneapolis Fed monetary advisor and assistant director for policy. In new research, however, Arellano and Minneapolis Fed Research Analyst Leonardo Barreto explicitly model the differing characteristics of official and private debt (Minneapolis Fed staff report 678, “Official Sovereign Debt”). In doing so, they create a model that more convincingly explains the observed flows of debt when sovereign borrowers run into trouble. The model also upends prior findings that prescribed short-term debt for countries in crisis.
The economists analyze World Bank data on 30 emerging market countries between 1970 and 2019, a period that featured sovereign debt defaults by dozens of governments across the Americas, Africa, Europe, and Asia. For these countries during this period, official debt comprised more than half of all sovereign borrowing. The shifting mixture of debt over time suggests that official debt and private debt play different roles in a default episode. Nigeria displays the typical pattern (see figure).
Private debt was the dominant form of debt when Nigeria’s prolonged period of partial default began. In subsequent years, official debt accelerated sharply while private debt, after some initial growth, steadily declined. At the exit from default, almost all debt was official.
In Nigeria’s case, overall debt-to-output grew by a factor of five during the default episode before declining again. This outcome is incongruous with canonical sovereign debt models that presume countries lose access to credit when they enter default. Prior models have also prescribed short-term debt as the optimal solution for defaulting countries because the consequences of default are severe and imminent, motivating repayment and fiscal discipline. But in Nigeria, as elsewhere, a different solution clearly dominates in practice: long-term debt, extended by official sources.
Arellano and Barreto augment a standard dynamic model of sovereign default to capture observed default behavior and meaningful differences between official and private debt. As in earlier models, sovereigns suffer random shocks to output. But default is now a continuous choice by the sovereign borrower, in each period, to partially default on zero to 100 percent of outstanding loans. Partial default affects the terms of credit, but credit remains available. In partial default, unpaid debts are not necessarily erased but can now be rolled forward into future transactions.
Crucially, official creditors are now in the picture, with different interests and lending terms than those of private lenders. While private creditors will “run” in the face of default or impose an exorbitant price to roll over existing debt, official creditors offer more concessionary pricing and longer duration loans. Think of the IMF or the Paris Club, the informal arrangement of developed countries that has restructured more than $600 billion of debt in the interest of “coordinated and sustainable solutions to the payment difficulties experienced by debtor countries.”
The economists emphasize how the long horizon of official creditors expands the credit available to the sovereign borrower, even in default. Because repayment obligations extend far into the future, the official lender feels more confident that the sovereign’s future borrowing is limited. “These contracts effectively constrain future borrowing and raise the overall debt capacity of the sovereign,” the economists write.
In deciding its optimal level of partial default in the model, the sovereign debtor weighs the cost of carrying forward its prior debts against the benefits of financing from official creditors, including the ability to postpone a painful fiscal adjustment and sustain consumption in the near term. Official creditors offer to restructure the existing debt with a “haircut” such that they break even in present-value terms.
When Arellano and Barreto parameterize their model with the 30-country World Bank data, the model generates an average duration of official debt that is twice as long as private loans (nine years versus 4.5 years). The ultimate recovery rate for official lenders is lower (41 percent of official debts owned, versus 52 percent of private). As in the data, official debt eventually dominates the landscape in the model as countries enter partial default, ultimately comprising 61 percent of all sovereign debt.
The economists model the paths taken by sovereigns that enter default with different mixtures of debt. Unlike prior models, borrowers take on additional debt during the first part of the default episode, even as they deleverage in the long term. Along most paths, the sovereign sheds private debt while acquiring official debt. In this and other respects, the new model looks much more like the observed interactions of sovereign borrowers and creditors in the past 50 years.
They explore the potential for swaps of private and official debt—even after sovereigns and creditors have negotiated to an equilibrium in the model—that would make all parties at least as well off. They find that there are many of these Pareto-improving swaps, in theory, although in practice the agents only arrive at such inefficient equilibriums about 5 percent of the time. Arellano and Barreto interpret these outcomes as extreme economic shocks like pandemics or natural disasters; in these circumstances, there may be a case to be made for intervention that improves outcomes for all.
Arellano and Barreto test whether even higher-welfare outcomes are possible if official creditors in the model extended short-term rather than long-term credit. (The received wisdom from prior research is that short-term loans are best for countries facing default.) They find short-term loans do not lead to better outcomes, validating the model design and the observed tendency of official loans from the IMF or Paris Club to carry much longer terms.
“Official Sovereign Debt” illuminates the scale and crucial role of bilateral and multilateral lending during developing-nation debt crises. Even so, the model likely understates the full importance of official creditors in global financial stability near the end of the 20th century. As Arellano and Barreto discuss, 18 countries in Latin America, Asia, Europe, and Africa restructured their debts under the Brady Plan between 1989 and 1997 (named for U.S. Treasury Secretary Nicholas Brady). While the complex deals featured some issuing of official debt (such as direct loans from the IMF and Japan), the heart of the plan was the replacement of private bank loans for new, tradeable Brady Bonds sold to investors—an exchange of one form of private debt for another.
However, the new bonds were made palatable for investors because they were backed by U.S. Treasurys as collateral, held in escrow at the Federal Reserve. “The involvement of the U.S. government helped increase the credibility of the program,” the economists write, “and was an important component in the resolution of the debt crises.”
Read the Minneapolis Fed staff report: “Official Sovereign Debt”
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.
