CAMBRIDGE – On Friday August 25, the US government imposed financial sanctions on Venezuela, restricting the ability of President Nicolás Maduro’s government and its oil company, PDVSA, to issue new debt in American capital markets. The sanctions were imposed in response to the regime’s unconstitutional and fraudulent election of a constituent assembly and the de facto closure of the constitutionally elected National Assembly, with its two-thirds opposition majority.
Well-functioning markets should have shut down the Maduro regime’s access to finance long ago. The fact that they didn’t not only shocked the moral sentiments of many, but also revealed a fundamental defect in sovereign debt markets’ institutional architecture. Little good will come from Venezuela’s economic catastrophe, but one positive outcome would be a reform that puts such markets on a more solid financial – and moral – footing.
All debts imply a commitment by the borrower to repay what was borrowed, with interest. In the case of public debt, the pacta sunt servanda principle implies that future governments are obliged to respect the commitments assumed by their predecessors. But, as Alexander Sack argued in 1927, successor governments should not always do so: “When a despotic regime contracts a debt, not for the needs or in the interests of the state, but rather to strengthen itself, to suppress a popular insurrection, etc., this debt is odious for the people of the entire state.”
According to this doctrine, debt incurred by “odious” regimes should not be enforceable, because the lender should have known that the debt was incurred without the consent of the people or for their benefit. As Sack put it: “This debt does not bind the nation; it is a debt of the regime, a personal debt contracted by the ruler, and consequently it falls with the demise of the regime.”
The odious debt idea was revived in an influential 2006 article by Seema Jayachandran and Michael Kremer, and in a 2010 report by the Center for Global Development (CGD), which proposed that economic sanctions include a mechanism aimed at preventing the accumulation of odious obligations. The mechanism would take the form of a declaration that debt issued by a particular government would be considered odious. In effect, this is what the Trump administration has just done.
Such a declaration reduces the flow of funds to odious regimes, owing to the risk that successor governments will renounce their predecessor’s debts without incurring legal and reputational costs (because participating countries’ courts will not enforce the debt contracts).
The CGD report proposes that a regime should be considered odious if it abuses the human rights of the population, employs military coercion, perpetrates electoral fraud, and mismanages or misappropriates public funds.
Clearly, the Venezuelan regime has ticked each of these boxes, making it a poster child for odiousness. But it did not tick them all at once: the plundering of Venezuela’s wealth, the gross violation of human rights, and the unconstitutionality of its decisions did not begin with the election of the new Constituent Assembly on July 30. It was a slow process that started many years earlier.
For example, it is difficult to argue that the destruction of the Venezuelan oil industry, which lost almost half its global market share since President Hugo Chávez took power nearly 20 years ago, was carried out in the interest of the Venezuelan people. And it happened amid the biggest and longest oil-price boom in history, at a time when the country was sitting on the world’s largest reserves and PDVSA was borrowing on a massive scale.
It is even harder to argue that PDVSA’s dollar-denominated debt was legitimate when it was sold for local currency at below-market prices, to politically connected individuals, who often borrowed the needed bolivars overnight from public-sector banks, just to flip the bonds immediately to Wall Street. As Barclay’s Alejandro Grisanti documented in 2008, beneficiaries pocketed an instant profit equal to 20-30% of the face value of the debt.
None of these considerations prevented the Venezuelan regime from borrowing, often at the ridiculous rate of 50%, as happened in May with Goldman Sachs’s purchase of “hunger bonds.” It also did not stop institutions such as JP Morgan from including Venezuelan bonds in their emerging-market bond indexes and purchasing more than $1 billion dollars of these bonds for the exchange-traded and mutual funds that it offers to the public as investment vehicles.
That is why we propose the adoption of an odiousness rating system, akin to credit ratings. While the latter focus on the ability and willingness of the borrower to pay, the odiousness rating would provide an estimate of how likely it is that a court would decide that the debt falls with the regime. The scale would be continuous, going from, say, O (odious repressive dictatorships) to W (well-managed and fully functioning democracies). There would be intermediate notches: dictatorships that promote economic development and thus benefit the population (think of South Korea in the 1970s) and corrupt democracies characterized by economic mismanagement and graft (think of Argentina during the Kirchner administration).
Odiousness ratings could become part of soft international law, used by courts when deciding how to enforce debt contracts, and they could help determine which bonds are included in the calculation of emerging-market indexes. The same country could have bonds which, being issued in different periods, have different odiousness ratings and enforcement probabilities. Because a more odious rating would reduce investors’ appetite for bonds, downgrades could limit the irresponsible debt accumulation and economic disasters brought about by regimes such as Venezuela’s – and possibly accelerate their demise.
There are many open questions. Who should issue the rating? What should the methodology be? How can the rater be protected from political pressure? But all of these questions can be answered. The best way to do that is to start the discussion.
Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is Director of the Center for International Development at Harvard University and a professor of economics at the Harvard Kennedy School. Ugo Panizza is Pictet Chair and Professor of Economics at the Graduate Institute, Geneva.
By Ricardo Hausmann and Ugo Panizza