Sovereign debt has a dual image. On one side, sovereign debt is regarded as a low-risk asset. The reasoning behind it is that a government cannot go bankrupt and could always find a way to meet its financial obligations by increasing taxes or printing money. In this line of thinking, the United States sovereign debt is often seen as the risk-free asset in finance textbooks. On the other hand, sovereign debt defaults exist, are not seldom and involve large amounts. Sovereign debt and default risk have always been considered as an important part of financial markets, but recently, they have been even more in the spotlight.
A large academic literature has tackled the question on the determinants of premiums required on sovereign debts. Indeed, bondholders could require a risk premium on bonds due to a potential repudiation. The argument behind the repudiation could be economic or odiousness. If the country does not repay its debt due to its economic situation, the argument behind the repudiation will be economic. If the country does not repay is debt using “illegitimacy”, “morality” or “unfairness” as a motivation, we are talking about repudiation due to odiousness.
What is odious debt?
An odious debt is a sovereign debt which meets the odious debt doctrine and therefore could be repudiated. If the debt meets certain criteria, the next government may refuse odious debts. This doctrine legitimises the repudiation of sovereign debt if the debt was, for instance, contracted by dictators for repression purposes, luxury expenses, corruption or crime. As the doctrine legitimizes international debt repudiation, it introduces a specific financial risk for bondholders. The repudiation of debts viewed as “odious” constitutes a major but seldom occurring impact on financial markets as history will show us.
The French public law teacher, Gaston Jèze (1922, p327), was the first to developed this concept under the name of “regime debt”. These debts were seen as “debts contracted in peacetime, but specially for the purpose of subjugating the liberated territory” and which “we should place on the same footing as war debts”. “Regime debts” are typically dictator’s debts incurred to oppress the population.
For several decades, the odious debt doctrine lied fallow. The demise of some despotic regimes, such as the Apartheid government in South Africa, woke the doctrine up. The juridical literature on the odious debt doctrine was used as a legal basis by activist to suggest successor governments should be relieved from dictator’s debts. This revival also attracted scholarly attention.
King, Khalfan and Thomas (2003, p13-16) suggested three conditions for a debt to be considered as odious. If the three criteria are fulfilled, the sovereign debt may be declared odious. The first and second criteria are that the debt has not received the general consent of the nation, and the borrowed funds are contracted and spent in a manner that is contrary to the interest of the nation. The third criterion is creditor’s awareness of these facts .
Many scholars (Buchheit et al., 2006; Cheng, 2007; Gelpern, 2007; Howse, 2007; Jayachandran et al., 2006; King, 2007) joined the debate. Based on this literature, we can conclude that the generally accepted rule is that sovereign debt has to meet the three following criteria to be declared “odious”:
- The debts had been issued without the population’s consent.
- The population would have received no benefit from the debt issue.
- The lenders knew that the proceeds would not be used for the population and that the population was opposed to the debt.
What can history tell us about odious debt?
Cuban debts in 1898 are the first case of odious debt. Other examples followed such as the Tsarist debt in 1918 or Polish debt incurred by the German occupiers during the First World War. More recently, in 1991, the Baltic Republics repudiated their portion of the USSR’s debt for their alleged odious character. The question of Saddam Hussein’s odious debt particularly arose in political, activist and media debates in 2004. Today, it is Hosni Mubarak’s debts that are under the spotlight for their odious character.
A first step consists of a global view of the different cases of odious debt. Table 1 has been constructed using various archives, legal literature and the more recent media reports, providing all the cases of debts which have been repudiated for their alleged odious character.
Those case studies have been divided into three types. Type “A” represents sovereign debt repudiated after the annexation of one country by another. Type “C” deals with debts repudiated as odious after a country went through a split or ceded part of its territory. Finally, if a country has experienced a change of government, without joining or splitting, leading to the repudiation of the debt, it is said to be a regime type of odious debt and is indicated as “R” type. Out of those cases of odious debt, two of them, Cuba and Russia will be analysed in this article.
Next to the nineteen sovereign debts repudiated for their alleged odious character (see Table 1), other cases have been put forward as potentially odious in the media, but have not yet been repudiated. Since the possible repudiation of Saddam Hussein’s debts in 2004 for reasons of odiousness, there has been renewed interest in the odious debt doctrine. The media has emphasised the repudiation of debts emitted by dictators. African countries are the most often cited as examples in the media. However a part of Argentine and Indonesian sovereign debts are also considered as odious debt by protest groups. Debts incurred during the apartheid regime in South Africa are a well-known example of odious debts that should be repudiated according to many groups. Dictators’ debts in African countries such as Nigeria and Congo are also considered by the media as sovereign debt which should not be repaid because of their alleged odious character. There is also a strong case for launching odious debt proceedings against “criminal” debts in Indonesia, but this has not been done to date. Argentina even submitted a proposal to declare foreign debt incurred by the military regime as odious. The list of possible candidates for odious debt status is long, and the amounts of debt involved are large, making this problem even more pressing.
This issue may be illustrated with a recent example: the Egyptian debt issued under the reign of Hosni Mubarak or Iraqi debt under Saddam Hussein. Figure 1 was heavily published in 2003 by protest groups against Iraqi debts emitted under Saddam Hussein. It represents a fake Iraqi banknote issued by Saddam Hussein mentioning the $130bn sovereign debt issued under his reign as well as the inscription “Thanks to all my creditors, Wars and palaces aren’t cheap! SH”. On the bottom of the note are the flags of the major creditors of this debt which was repudiated as odious.
How big is the financial penalty of odious debt?
Collet (2013) and Collet and Oosterlinck (2014) highlight empirically the financial implications underlying the concept of odiousness. These papers tackle the risk premium required by investors to hold potentially odious debts by analysing two case studies from the late 19th century and early 20th century. Indeed, the odious character of the debts induces a higher default risk. These papers aim to quantify if there is a risk premium required by investors to hold such debts which could be declared as odious. It also analyses the evolution of the value of sovereign bonds during extreme “odious debt” events.
The Cuban bond market during the 19th century could be considered a perfect case study. After the war, only part of the Cuban debt was at first disputed due to its alleged odious character. The rest of the Cuban debt was not initially seen as odious but was “unexpectedly” declared as odious and repudiated. Investors expected that debts incurred to refinance old debts, and not to finance the oppression, would not be seen as odious. As a result, it came as a shock when this part of the Cuban debt was also repudiated. The “odiousness” effect on the risk premium required by investors can be isolated thanks to this change in perception and its impact on the bond market. The change of perception is an unexpected exogenous shock. In this situation, the difference in anticipation between the parts of the debt makes it possible to determine the perceived repudiation risk. A Structural VAR approach was applied to the original database of Cuban bonds to disentangle the effects of news and events related to the war from those linked to whether debt was regarded as odious. At the time of independence, Cuban debt was not only influenced by default risk due to its odious character but also impacted by the Spanish-American War. The paper highlights the existence of odiousness shocks and determines their financial impact by comparing the results of the econometric analysis with the events reported in newspapers. It puts forward the existence of a risk premium of at least 200 basis points.
Collet and Oosterlinck (2014) investigates the existence of a risk premium to hold debts issued by the Tsarist regime. Is a possible future repudiation perceived as credible by the markets? Is the market impacted by organised protests? In this perspective, this paper analyses the 1906 Tsarist loan. This loan was contested by the opposition to the autocratic Tsarist regime because it was seen as assisting the despotic regime to suppress opposition. Several authors (Landon-Lane and Oosterlinck, 2006; Oosterlinck and Ureche-Rangau, 2008) have analysed Russian loans in the 20th century but they only dealt with the stakeholders’ position during the negotiations and the debt was only repudiated in 1918. The Duma, a national consultative assembly elected by the people, was created in 1906. The sovereign debts being approved by the Duma were issued with popular consent. As the concept of odious debt requires the debt to be imposed on the people, sovereign debts approved by the Duma do not fit the legal definition to meet the odious status. This provides the opportunity to classify Russian debts as odious or non-odious. It reveals that, despite the efforts made by the Russian government to present this controversial loan as legitimate and not odious, a premium was required by the market to hold it. The premium was varying between 300bp and 20bp. The variation was mainly due to the amount of “bad press”. The paper finds a risk premium of 300bp when the bad press against the 1906 loan hit it’s peak. When the bad press diminished, this premium declined as well..
What model is behind this risk premium?
Those two papers put forward the existence and quantify the risk premium r odious incurred in case of an odious debt.·
r odious = Pchgt.P1.P2.P3.Loss
The odious risk premium is a function of the three criteria ( P1 , P2 and P3 ), the probability of government change (Pchgt) ) and the expected loss ( Loss ). P1 , P2 , P3 and have values between 0 and 1. The value 0 is attributed when the probability of meeting the criteria is null. P1 , P2 and P3 are the three critera which specify if the debt is odious. If all three criteria are met , P1 , P2 and P3 are of value 1 so that the risk is present. On the contrary if one of the critera is not met, the relative P has a value of 0 which means that the risk does not exist as the debt can not be declared odious. The expected loss ( Loss ) is the expected value of the loss if the government changes ( Pchgt = 1) and the debt is declared odious ( P1 , P2 and P3 = 1).
To conclude, we highlighted the risk premium required by investors to hold potentially odious debt by analysing two case studies from the late 19th and early 20th century. Indeed, the odious character of debt induces a higher default risk. This can be modelled using the definition of odious debt. When the probability of meeting the three criteria of odious debt and the probability of government change is high, bondholders are likely to require an odious risk premium.
