Haircuts and the cost of sovereign default

by Juan José Cruces and Christoph Trebesch

Vox
October 13, 2011

What are the financial costs of a sovereign default? This column presents new data on investor losses – haircuts – in all sovereign debt restructurings between 1970 and 2010. Countries imposing high haircuts take significantly longer to reaccess capital markets after the event and subsequently pay higher interest rates.

Thirty years of research in international finance comes to a puzzling conclusion: A country that defaults on its debt does not seem to face serious penalties in credit markets in the medium and long run. The effects of defaults on borrowing costs are small or short-lived, and defaulters often regain access to new capital just one year after the crisis (see for example Panizza et al 2009 and Gelos et al 2011). These results stand in sharp contrast to economic theory, which suggests reputational punishment and market exclusion.

This column reassesses the empirical findings on the costs of sovereign default and questions the consensus view that credit markets have short memories. In contrast to earlier literature, we focus on actual default outcomes (ie investor losses), not only on the occurrence of default per se (ie any missed payment). Our intuition is simple: A haircut of 77%, as in Argentina in 2005, is likely to have different implications to a haircut of 10%, as in the restructuring of Uruguay in 2003. This basic idea, however, could not be tested before, primarily due to a lack of sufficient data on restructurings and haircuts.

The study makes two contributions. We first construct a comprehensive archive of all sovereign debt restructuring cases vis-à-vis foreign banks and bondholders between 1970 and 2010. For this purpose we gathered and cross-checked data from more than 200 sources, including the IMF archives, books, policy reports, offering memoranda, private sector research and articles in the financial press. Like in Sturzenegger and Zettelmeyer (2006) we compute haircuts based on the difference between the present values of old and new instruments, discounted at market rates prevailing immediately after the exchange. In a second step, we use the haircut data to study the relationship between restructuring outcomes and subsequent borrowing conditions for debtor governments.

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