“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”

Financial Mirror (Cyprus) - - FRONT PAGE -

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 i mposed 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 i mplies 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 Cen­tre 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 dol­lar­de­nom­i­nated 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 Bar­clays’ 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 emerg­ing­mar­ket 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 char­ac­terised 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.

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