Applying the Odious Debts Doctrine while Preserving Legitimate Lending

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Seema Jayachandran; Michael Kremer; Jonathan Shafter (2006). Applying the Odious Debts Doctrine while Preserving Legitimate Lending.

Type	working paper
Scope	Comparative and methods
Method	theoretical or conceptual
Period studied	1985–2005
Regions	South Africa, Croatia, Iraq, Nicaragua, global sovereign lending
Themes	sanctions divestment, macro fiscal finance debt, comparative theory, transition post apartheid
Citation key	jayachandran2006

Argument

The paper argues that odious debts, incurred by regimes without popular consent or a public purpose, should be repudiable by successor governments in strictly limited cases. Using a reputational model of sovereign borrowing, it shows that successors repay such debts to keep access to credit. Credible loan sanctions would remove that incentive, so creditors would not lend to odious regimes. Loan sanctions are self-enforcing and less harmful to the population than trade sanctions. The authors criticise the judicial 'Classical Model' as too uncertain for lenders and propose a prospective 'Due Diligence Model'. Under it an international body designates regimes as odious-debt prone ex ante, and creditors to those regimes must follow pre-approved monitoring plans. South Africa appears only as an illustrative case.

Evidence and method

A stylised theoretical model (a palace-building dictator, a reputational equilibrium and propositions), drawing on Bulow and Rogoff (1989). It is supplemented by anecdotal cases (Somoza/Nicaragua, Tudjman/Croatia, Iraq, South Africa), newspaper reports, policy documents and legal sources.

Findings

• The authors suggest the UN could have used a debt declaration alongside its 1985 sanctions on apartheid South Africa to deter lending. (p. 5)

  when the United Nations imposed trade sanctions against the apartheid government of South Africa in 1985, it also could have declared that it would not consider debt incurred by the apartheid government as a legitimate obligation

• Post-apartheid South Africa kept servicing apartheid-era debt to retain investor confidence. (p. 11)

  the South African government, in order to remain in the good graces of investors, has distanced itself from the popular movement to nullify its apartheid-era debts.

• Loan sanctions are self-enforcing because creditors cannot defect profitably, unlike trade sanctions. (p. 4)

  banks cannot break this sanction unilaterally since they rely on others to enforce the “reputational punishment” that operates in the debt market.

• In the model, successors repay odious debts because of the reputational value of future credit access. (p. 11)

  successor governments, concerned about their reputation, typically accept responsibility for debt, independent of the nature of the preceding regime.

• If repudiation carried no reputational cost, creditors would not lend to odious regimes at all. (p. 12)

  if the successor to an OD-prone regime repudiated debts regarded as odious without impacting the successor’s access to credit then not only would it most likely repudiate those debts

• Loan sanctions can leave the population better off than trade sanctions, if the gain from not inheriting debt outweighs the short-run cost. (p. 14)

  If the gain from not inheriting debt outweighs the short-term economic cost of a sanction, which seems plausible, then ex post a loan sanction is welfare-improving

• The Classical Model's judicial test is too vague about democracy, which would chill legitimate lending. (p. 17)

  There are simply no legal definitions of democracy or dictatorship with sufficient clarity for a judicial forum to rule upon.

• The Due Diligence Model invalidates a loan only if funds are diverted and the lender failed to follow its pre-approved plan. (p. 3)

  A loan would only be invalidated if the funds were diverted towards illegitimate ends and the lender failed to make a good faith effort to comply with its own pre-approved due diligence plan.

• Commercial lending to Croatia continued after the IMF cut off aid, illustrating the weakness of existing sanctions. (p. 5)

  commercial banks lent an additional $2 billion to the Croatian government between the time of IMF decision and Tudjman’s death in December 1999.