Optimists say that emerging market defaults are a thing of the past. Emerging markets today, the argument goes, are relying more on domestically issued local currency debt, both inflation-indexed and non-indexed. This means their debts are far more stable and reliable than in the recent past, when a much larger share of government debt was issued externally and denominated in hard currency.
This argument is wrong. In the past, the combination of high levels of domestic debt and inflation surges has often proven deadly for both foreign and domestic investors. Just look at Argentina today, a country not nearly as prosperous as its abundant natural resources would warrant.
Already, a good share of Argentina’s debt is in default. What else do you call it when a government that owes more than $30 billion in inflation-indexed debt manipulates its consumer price statistics? Through a variety of crude measures (such as firing its top statisticians), the government is publishing an understated inflation rate that is used for calculating indexation payments. The official inflation rate in Argentina for the past 12 months is under 10%. But the true rate appears to be at least 30%, according to virtually every neutral source.
Fudging indexation clauses to effectively default on debt is an old game. During the second half of the 1980s, Brazil abrogated inflation-indexation clauses embedded in its debt contracts. In the Great Depression, the US government revalued gold to $35 per ounce from $20, effectively rewriting the contracts of foreign holders of US debt.
If external debt holders think that abuse of domestic debt holders is no cause for alarm, they should think again. Governments do not usually cheat holders of only one type of debt. In April, we published a National Bureau of Economic Research paper based on centuries of debt data from many countries. We found that most countries default on external debt only a bit less freely than on domestic debt. That is, contrary to popular belief, domestic debt holders are not necessarily a cushion for “senior claimants” holding externally issued debt.
In the course of history, emerging markets have had a hard time shaking off serial default. A period of quiescence has been invariably followed by more turmoil, with the share of total countries in the world in default sometimes exceeding 40%, as it did during the mid-19th and 20th centuries.
Considering the duress of domestic bond holders across the world as inflation rises, it is surprising that both private investors and multilateral financial institutions seem complacent about the rising risks of defaults.
The “this time is different” mentality is based on two mistakes. The first is that domestic debt is something new. The other is the faulty economic logic that payments to domestic debt holders come out of a different pot than one to external debt holders.
There have been many episodes in the past where rising levels of domestic debt have sharply raised risks to external debt holders. There is nothing new about the rise of domestic debt markets. They are simply growing again after suppression during the high-inflation 1980s and 1990s.
Earlier eras offer scant evidence that external creditors have been safer than domestic ones. When India effectively defaulted on its domestic debt by massive inflation and financial repression in the early 1970s, external debt holdings suffered payment reschedulings.
Emerging markets could be in much greater trouble than the optimistic consensus suggests. If today’s tepid growth in the US, Japan and Europe begins to take hold in emerging markets, Argentina’s miserable indexed bond holders may soon have company.
THE WALL STREET JOURNAL
Edited excerpts. Carmen M. Reinhart is a professor of economics at the University of Maryland and Kenneth Rogoff is a professor of economics at Harvard University. Comments are welcome at firstname.lastname@example.org