What Does the History of Defaults Teach Us?


In an episode of the “Economics Out Loud” podcast, NES Vice-Rector Maxim Bouev discussed with the podcast editor Philip Sterkin a recently announced default of Russia, which he considers a unique event. Why is the government doing the right thing by trying to pay off its debt? How has the debt structure changed over the course of history? What can be the impact of a default on the economy? Below, we share the main ideas of the episode. 


Why Is Russia Trying to Pay Its Debt

Since the mid-1970s, every given year more than 30% of all countries globally have been in the state of default , Rui Esteves, Sean Kenny and Jason Lennard show in a study. Meanwhile, although defaults have been thoroughly studied for a long time, they are still far from a clear phenomenon. For example, any monetary reform that reduces the population's well-being or its purchasing power is akin to a default on domestic debt. 

Researchers divide sovereign defaults into two categories:

- endogenous, which result from economic stagnation or macroeconomic imbalances, and

- exogenous, i.e. caused by external causes, including political ones.

Before WWII, most defaults had an external origin, they were caused by legal or political problems, deterioration of terms of trade , etc. In the post-war period, the situation changed: the share of endogenous defaults increased.

The default of Russia, which was announced by Moody's rating agency, is exogenous. And this case is certainly unique: debt payments are missed, although the country can, wants and tries to make them. We cannot  immediately assess the consequences of the event. Research shows that sometimes the cost of borrowing after a default rises strongly and for a long time , and sometimes investors quickly forget about the default and interest rates on foreign debt return to an acceptable level. Therefore, the Russian Ministry of Finance and the Government were doing the right thing when they were looking for options to pay off the debt until the last moment and offered possible schemes to investors so as to maintain Russia's reputation of a reliable borrower in international markets. The country has a very good history in this sense: the most famous default was in 1918, and after that neither the Soviet Union nor post-Soviet Russia has allowed defaults on foreign debt. 

The impact of a default on the economy depends on a lot of things. For example, in Russia, the default of 1998 became the low point of the transformational recession and the beginning of a period of economic growth that happened due to both reforms, such as the one in the tax system, and a lasting upturn in oil prices. And this combination of factors has provided Russia with 10 years of economic growth.

In many ways, the consequences of a default depend on its causes. If the default was caused by a shock of aggregate demand, the economy quickly recovers, returns to growth and is able to borrow relatively cheaply. The consequences of a default caused by an aggregate supply shock may be more lasting. 

A successful exit from the crisis requires a monetary and fiscal space that allows the authorities to act, Christina Romer and David Romer (both from the University of California at Berkeley) show in their research. If the federal debt is too large, and the central bank's key rate is close to zero, then the government cannot increase spending, and the central bank has no capacity to stimulate lending by lowering the borrowing rates.


Lender’s Haircut

Until the 1950s, there was no way  to limit the sovereignty of a country declaring default in a lending agreement - investors were losing  everything. Since then, debt issuance prospectuses began to include provisions allowing creditors to sue the country in the case of default. About 90% of creditors usually agree to debt restructuring in the form of new bonds with more favorable terms: lower face value, longer maturity, and smaller coupon. A successful restructuring allows creditors to recover a portion of their money, and the country is relieved from the burden of unaffordable interest payments. At the same time, investors can recover losses fairly quickly.


After Russia's default in 1998 investors recovered their losses already in 2001, according to a research paper by Carmen Reinhart (former Chief Economist of the World Bank Group), Josefin Meyer and Christoph Trebesch (both from the Kiel Institute for the World Economy). 

Meanwhile, the remaining 10% of creditors who are not willing to accept the restructuring (holdout creditors) can create big problems for the debtor country. An interesting and important case is that of Argentina (it has already had nine defaults) and its most famous default of 2001, after which the country could not recover for a long time, due to, among other things, the litigation with creditors that lasted for many years. By a mistake, the bond offering  prospectus did not specify how, in case of a default, an agreement would be reached with creditors who would not agree to the restructuring. As a result, vulture funds were able to freeze payments even to those investors who agreed to the terms of the restructuring.

The emergence of Brady bonds played an important role in the developing countries debt restructurings . These market traded bonds helped resolve debt crises, but were often bought by vulture funds.


The debt-reduction plan for Latin American countries was named after former US Treasury Secretary Nicholas Brady. The initial bonds could be converted into securities with more favorable terms, that were collateralized by US Treasury bonds, which were paid for by the indebted countries with the financial support of the IMF and the World Bank. By the mid-2000s, most Brady bonds had been exchanged or redeemed. According to the Trade Association for the Emerging Markets, in 1994 they accounted for 61% of emerging market debt trading, and by 2005 their share had fallen to 2%.


How to Prevent a Global Debt Crisis?

Today, there is a risk of a global debt crisis associated with a high level of accumulated debt (in 2021 global government debt was 97% of GDP, in developed economies it reached 120% of GDP, and in developing economies it was 66% of GDP, while the IMF expects a reduction in the government debt of developed economies and its growth in developing countries), and the rising interest rates due to accelerating inflation. Energy and food prices have spiked causing particularly big problems for poor countries. 

One of the reasons for this price increase is the political situation in the world. The works of Carmen Reinhart and Harvard University professor Kenneth Rogoff show that government debt peaks at the time of wars and revolutions. Russia's default in 1998 also occurred after the war in Chechnya, which ended in 1996.

The end of hostilities in Ukraine is the main step that must be taken at the global level in order to prevent a wave of defaults. In addition, measures to slow down inflation and a new mechanism for restructuring the debt of developing countries are needed. These economies need aid and investments. After all, if a country has good economic growth potential, then even a large debt will not seem like a disaster, since the debt to GDP ratio will start to decline.

One of the arguments that sounded at a session of the St Petersburg International Economic Forum with NES Professor Oleg Shibanov, claimed that Russia could accumulate the risks of developing countries: it could lend them money at rates lower than the market average. Market investors do not like risk very much, and the higher interest rates that developing countries pay is a compensation for investors' willingness to lend money. If Russia, in a certain sense, acts on the international market as a reckless investor who is ready to lend money to developing countries at lower rates, then why not do this. It is just another investor with a special attitude to risk that will appear on the market.