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The Long and Winding Road to a Haircut

CAMBRIDGE – Default is back. Sovereign finances weathered a wrenching global recession and a collapse in commodity prices surprisingly well over the past few years. But failed economic models cannot limp along forever, and the slow bleeding of the economies of Puerto Rico and Venezuela have now forced their leaders to say “no mas” to repaying creditors.

Earlier this year, Puerto Rico declared bankruptcy. At the time, the United States commonwealth had about $70 billion in debt and another $50 billion or so in pension liabilities. This made it the largest “municipal” bankruptcy filing in US history.

The debt crisis came after more than a decade of recession (Puerto Rico’s per capita GDP peaked in 2004), declining revenues, and a steady slide in its population. The demographic trends are all the more worrisome because those fleeing Puerto Rico in search of better opportunities on the US mainland are much younger than the population staying behind. And in September, at a time of deepening economic hardship, hurricane Maria dealt the island and its residents an even more devastating blow, the legacy of which will be measured in years, if not decades.

More recently, in mid-November, Venezuela defaulted on its external sovereign debt and debts owed by the state-owned oil company, PDVSA. Default on official domestic debt, either explicitly or through raging hyperinflation, had long preceded this latest manifestation of national bankruptcy.

While the government and PDVSA owe about $60 billion to foreign bondholders, these entities reportedly owe a comparable (if not larger amount) to Russia and China. According to the International Monetary Fund’s most recent World Economic Outlook, Venezuela’s real per capita GDP has contracted nearly 40% since 2008. By 2022, the cumulative toll is expected to leave per capita income at about half its level a decade ago. Such an economic collapse, rare outside wartime, understates the extent of human suffering implied by the prolonged food and medicine scarcities that plague the country.

Sovereign debt restructuring has a long and often torturous history. Relatively few cases have been resolved quickly or amicably, and they are usually cases where the restructuring involves only some concession on the interest rate and a lengthening of maturities on outstanding debt. They usually do not involve writing off a substantial portion of the principal owed. In other words, there is no significant “haircut” for creditors and only limited debt relief, at best, for debtor governments.

Obviously, there are significant differences between Puerto Rico and Venezuela regarding the origins of their economic crises, their political systems, their relationship with the US and the rest of the world, and much else. Nonetheless, some notable similarities are likely to emerge as their debt sagas unfold.

For starters, prompt resolution can be ruled out (or nearly so) in both cases. As Christoph Trebesch and I document, a common pattern in the often-hostile back and forth between sovereign debtors and their creditors is the protracted nature of the resolution process. Initial restructuring terms often are too timid, relative to the haircut needed to restore solvency. As a result, restructuring efforts have often been piecemeal.

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Moreover, this pattern has emerged whether the creditors are bondholders (as in the case of Puerto Rico’s debt and about half of Venezuela’s), commercial banks, or official creditors (as in Greece). For example, between the early 1980s and 1994, Brazil had six different external debt restructuring deals, and Poland had eight, before the decisive restructuring under the more encompassing Brady Plan restored medium-term debt sustainability.

Another similarity between Puerto Rico and Venezuela that is likely to emerge stems from the severity of the economic damage that has already been sustained. Our work suggests that the size of the cumulative haircut is linked to the magnitude of the realized output losses. And, for both economies, bleak recovery prospects cast a long shadow over payment capacity.

On that basis alone, the haircuts will likely be on the high end of historical experience. Venezuela’s previous debt restructuring, during the emerging-market crisis of the 1980s, was almost 40% (see figure). Research by Juan Cruces and Trebesch, who provide estimates for the size of debt write-offs, shows that in almost half of the 64 restructuring episodes from 1980 to 2011, the cumulative haircut ended up amounting to more than 50%. In 15 cases, more than 75% of the face value of external debt was effectively written off.

Ambitious recent proposals to provide comprehensive assistance to battered Puerto Rico could, in principle, facilitate debt restructuring, though it is too early to say. Venezuela’s ever-more reprehensible regime under President Nicolás Maduro, and the uncertainty created by competing claims (mostly Western bondholders versus Chinese and Russian collateralized loans) sets the stage for a prolonged process culminating in substantial haircuts. While creditors should revise their expectations downward, the real tragedy is for ordinary citizens, for whom the restructuring process implies a protracted period of worsening impoverishment.

Carmen M. Reinhart is Professor of the International Financial System at Harvard University’s Kennedy School of Government.

By Carmen M. Reinhart

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