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Domestic Debt (This Time is Different)

Mexican Dollar-Linked Domestic Debt: The “Infamous” Tesobonos

To stabilize inflation in the late 1980’s, the Mexican peso was tied to the U.S dollar via an official exchange rate band. It was a peg to the U.S dollar. In early 1994, the peso came under speculative pressure after the assassination of a Mexican presidential candidate Colosio. To reassure U.S investors high exposed to Mexican treasury bonds that the government would maintain the value of the peso, the Mexican authorities linked it’s short term debt to the U.S dollar by means of “tesobonos,” short-term debt instruments repayable in pesos but linked to the U.S dollar.

By December 1994, when speculation against the currency broke out again, nearly all domestic debt was in U.S dollar. By the end of the year, the peso was allowed to float; it instantly crashed. A twin currency emerged along with a banking crisis into early 1995. If it wasn’t for a record bailout package by the IMF and U.S government, Mexico would have faced default on its sovereign debts. The central bank’s dollar reserves had nearly been depleted and would not be enough to cover maturing bonds.

Tesobonos were dollar linked and held mostly by non-residents – the situation was similar to what happened in 1982, when Mexico defaulted on its external debt to U.S commercial banks. But in 1995, the twist was that if default proceedings had been necessary, they would have come under the jurisdiction of Mexican law. This episode increased global awareness of the vulnerability associated with relying on foreign currency debt of any kind. But this experience did not stop Brazil from making the same mistake.

Argentine U.K. Pound–Denominated “Internal” Bonds of the Late Nineteenth and Early Twentieth Centuries

After Argentina defaulted on its first loans in the 1820s and remained outside the international capital markets until the late 1860s. Argentina issued many bonds in London, but both their external and internal bonds were denominated in U.K. pounds. A 100 years later, after fighting and losing a long war with chronic high inflation, Argentina’s domestic debts (and banking sector) would become almost completely dollarized.

Thailand’s “Curious” Dollar-Linked Debt of the 1960s

Thailand did not have a history of high inflation. They experienced two large devaluations in the 1950’s, which had only moderate inflationary impact. But for mysterious reasons, between 1961 and 1968, the Thai government issued dollar-linked domestic debt. Demestic debt, at the time, accounted for 80-90 percent of all government debt. Around 10 percent of the domestic debt stock was linked to the U.S dollar. Thus, the Thai episode was not a case of significant “liability dollarization. “The authors do not know who owned the domestic dollar-linked debt – such data may provide a clue as to they it came about in the first place.

Some Caveats Regarding Domestic Debt

Why would a country default on domestic debt if it can simply inflate the problem away? Inflation causes distortions, especially to the banking system and financial sector. Sometimes governments see repudiation as the less costly option such as the U.S in 1933. Default (abrogation of the gold clause) was a precondition for re-inflating the economy through expansionary fiscal and monetary policy.

Real GDP in the Run-up to and the Aftermath of Debt Defaults

How bad are macroeconomic conditions on the eve of a default? Output declines before default on domestic debt are much worse than those seen prior to a default on external debt. Output decline, on average, in the year of domestic debt crisis is 4 percent. For external debt, it is 1.2 percent.

Inflation in the Run-up to and the Aftermath of Debt Defaults

During domestic debt crises, inflation rates average 170 percent in the year of the default. After the domestic default, inflation stays at or goes higher than 100 percent in the following years. Not surprisingly, default through inflation goes hand in hand with domestic default.

Summary and Discussion of Selected Issues

The authors have presented the first attempt at a cross-country international catalog of historical defaults on domestic public debt, spanning two centuries and sixty-six countries.

How domestic debt impacts inflation and external default will vary across episodes and circumstances. Sometimes, domestic debt is eliminated through high inflation, in other cases, governments default on external debt.

How did domestic public debt in emerging markets go undetected to most economists?

Many researchers, after the difficulties of emerging markets in issuing debt in the hyper-inflationary 1980s and 1990s, thought that no one would voluntarily lend in domestic currency to kleptocratic governments of an emerging market. No one would trust such a government to resist inflating such debt down to nothing.

Why so many governments do not make it easier for standard databases to incorporate their debt histories is an important question for future academic and policy research. From a policy perspective, a plausible case can be made that an international agency would be providing a valuable public good if it could enforce (or at least promote) basic reporting requirements and transparency across countries. Indeed, it is curious that today’s multilateral financial institutions have never fully taken up the task of systematically publishing public debt data.

"Silence is the best expression of scorn" - G.B. Shaw

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