This blog post examines why national debt is repaid despite limited enforcement tools. It explores the actual drivers behind national debt fulfillment through various economic hypotheses and empirical studies.
Private debt contracts are enforced by courts. If a company refuses to repay its debts, court proceedings can lead to forced asset sales or liquidation. But what about sovereign debt? Traditionally, states have been protected from debt enforcement under the principle of sovereign immunity, which holds that a state cannot be tried in a foreign court without its consent. Although the general trend today is that sovereign immunity does not apply to a state’s commercial transactions, enforcing the fulfillment of sovereign debt through the courts remains difficult.
For this reason, many economists have focused on why sovereign debt is actually repaid despite the very limited legal sanctions or remedies available for sovereign default, seeking to find the answer. One starting point for this discussion is Eaton’s classic hypothesis. He argued that when GDP declines, a debtor country cannot secure funds to counter the GDP decline through means other than foreign borrowing. Furthermore, if default meant permanent exclusion from credit markets, the inability to regain access to those markets would be a sufficient reason for debt repayment.
However, this hypothesis subsequently faced strong criticism on two fronts. The first criticism pointed out that the assumption that foreign borrowing is the only recourse to maintain aggregate demand during GDP decline is unrealistic. If other policy tools exist to mitigate recession, the necessity for foreign borrowing to sustain aggregate demand during downturns diminishes, thereby weakening the deterrent effect of the threat of exclusion from credit markets. The second criticism concerned the validity of the assumption that default leads to permanent exclusion from credit markets. Once default occurs, it is often more advantageous for creditor countries to resume credit transactions than to enforce permanent exclusion. Empirical data also fails to support the Eaton hypothesis. Over the past 30 years, countries that experienced default were able to regain access to international capital markets relatively quickly. The average period of exclusion from capital markets after default was approximately four years in 1980, shortening to less than two years thereafter.
Researchers following Eaton sought to construct new hypotheses without directly adopting his assumptions. These hypotheses generally fall into three categories. First, there are hypotheses that attribute the reason for debt repayment to direct sanctions by creditor countries, such as trade sanctions or asset freezes. Second, hypotheses grounded in the logic that debtors repay out of concern for credit market repercussions, such as increased borrowing costs. Third, hypotheses focusing on the damage to the debtor country’s domestic economy caused by default.
Empirical work to verify these is conducted indirectly through quantitative analysis of the effects of sanctions imposed after default and the resulting domestic economic damage. First, the direct sanction effect by creditor countries can be gauged by measuring the extent of trade volume reduction. Indeed, numerous cases show trade volume declines in countries that declared default. However, the duration of this trade reduction is relatively short, lasting about 3-4 years, making it difficult to explain debt repayment solely by the risk of trade sanctions.
Next, the reputational effect in credit markets can be verified by measuring the magnitude of changes in borrowing rates. Empirical research based on data from 1997 to 2004 indicates that the spread increased by approximately 4 percentage points in the first year after default, but decreased to 2.5 percentage points in the second year, and after the third year, it was difficult to find a statistically significant level. Given that the increase in the spread is not only modest but also declines rapidly, except for the short period immediately after default, it is difficult to conclude that a decline in credit market reputation is the primary reason for debt fulfillment.
Finally, whether debt default negatively impacts the domestic economy can be assessed by measuring changes in GDP growth rates. Recent empirical studies indicate that debt default reduces GDP growth by approximately 0.6 percentage points, and when accompanied by a banking crisis, the reduction reaches 2.2 percentage points. Although the effect on GDP growth rate diminishes to a statistically insignificant level one year after the default, it is clear that even a temporary decline in GDP growth rate represents a permanent loss. Therefore, if the specific channels through which defaults cause GDP declines are clearly identified, the explanatory power of this hypothesis would be further enhanced.
