Odious debts and vultures

The British High Court has ruled that Zambia has to make substantial payments on its debt now held by Donegal International, based in the British Virgin Islands. Donegal International is a so-called vulture fund – that is, a financial organization that buys at a discount bonds that are very unlikely to be repaid, and then tries to sue the issuer for the full amount.

Ordinarily, I would be in favour of allowing markets to trade securities, and for companies to be able to enforce contracts against governments. Well-functioning and liquid secondary markets help to reduce the cost of capital when it is originally borrowed, and the subsequent trading at below par enables debt and risk to be priced.

VultureBut there is an obvious market failure here: it is the collective action problem of dealing with defaults. We have a solution for companies: when a company can no longer meets its debts, it goes bankrupt. This is an orderly procedure to ensure that the creditors receive their share of the debtor’s assets. In particular, bankruptcy prevents free riders from holding out for full repayment of their debts once other creditors have settled. But as Walter Wriston famously remarked, countries don’t go bust. Once a country’s debts become unsustainable, it is in everyone’s interests to restructure those debts. If there is no collective mechanism for restructuring, then creditors will scramble to be repaid at the first sign of trouble, which is in nobody’s interest. And if free-riders hold out for full repayment, then there will be less money for the other creditors and less prospect of an equitable and sustainable settlement. That is why we have the London Club (for private creditors) and Paris Club (for public creditors). But the Vulture Funds hope to free-ride on these collective mechanisms, and seek the repayment of debts in full once the other creditors have bailed out the country and restructured its debts.

There is a possible solution to this, which is related to the idea put forward by Michael Kremer and Seema Jayachandran. First, laws in creditor countries such as the UK and US could be changed to disallow seizure of a country’s assets for non-repayment of so called ‘odious debt’. In other words, we could change the law so that odious debt contracts are legally unenforceable. Second, foreign aid to successor regimes could be made contingent on non-repayment of odious debt. This would encourage successor governments to repudiate odious loans, which will encourage banks to refrain from originating them.

Who would determine what debts are odious? Kremer and Jayachandran suggest that we give a mandate to an international institution such as the UN or the IMF to declare a regime odious. For example, Mr Mugabe’s government in Zimbabwe would be declared odious. Any organization considering lending money to that government would know that the debts would be legally unenforcable. In addition, I suggest that we agree that any outstanding sovereign debts of a country that receives HIPC debt relief would also be automatically declared to be odious. This would mean that lenders today would be wary of making any sovereign loans to a country that might in the future run into a debt crisis.

An automatic mechanism to make debts unenforcable if they were lent to a government that was corrupt or incompetent, or if they contributed to a debt crisis, would impose a much stricter market discipline on lenders to make them think twice before making such loans; and it would also close down the free-riding activities of vulture funds.

Romania lent $30m to Zambia in 1999, when Frederick Chiluba was President of Zambia. Chiluba is under multiple charges of corruption and bribery. If those charges are made to stick, then the country’s debts which were incurred under his regime should, in my view, be declared odious and unenforcable in international courts. And that would mean that the vulture funds would not get paid.

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