Stephania Bonilla Odious Debt GABLER RESEARCH Ökonomische Analyse des Rechts Herausgegeben von Professor Dr. Peter Behrens Professor Dr. Thomas Eger Professor Dr. Manfred Holler Professor Dr. Claus Ott Professor Dr. Hans-Bernd Schäfer Professor Dr. Stefan Voigt (schriftführend) Universität Hamburg, Fakultät für Rechtswissenschaft und Fakultät für Wirtschafts- und Sozialwissenschaft Die ökonomische Analyse des Rechts untersucht Rechtsnormen auf ihre gesellschaftlichen Folgewirkungen und bedient sich dabei des methodischen Instrumentariums der Wirtschaftswissenschaften. Sie ist ein interdisziplinäres Forschungsgebiet, in dem sowohl Rechtswissenschaftler als auch Wirtschafts- wissenschaftler tätig sind und das zu wesentlichen neuen Erkenntnissen über Funktion und Wirkungen von Rechtsnormen geführt hat. Die Schriftenreihe ent- hält Monographien zu verschiedenen Rechtsgebieten und Rechtsentwicklungen. Stephania Bonilla Odious Debt Law-and-Economics Perspectives With a foreword by Prof. Dr. Hans-Bernd Schäfer RESEARCH Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografi e; detailed bibliographic data are available in the Internet at http://dnb.d-nb.de. Doctoral thesis, University of Hamburg, Graduiertenkolleg Recht und Ökonomik, 2010 1st Edition 2011 All rights reserved © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011 Editorial Offi ce: Stefanie Brich | Sabine Schöller Gabler Verlag is a brand of Springer Fachmedien. Springer Fachmedien is part of Springer Science+Business Media. www.gabler.de No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photo- copying, recording, or otherwise, without the prior written permission of the copyright holder. Registered and/or industrial names, trade names, trade descriptions etc. cited in this publica- tion are part of the law for trade-mark protection and may not be used free in any form or by any means even if this is not specifi cally marked. Cover design: KünkelLopka Medienentwicklung, Heidelberg Printed on acid-free paper Printed in Germany ISBN 978-3-8349-2993-8 Foreword If a private creditor gives a loan to a private person, knowing that the money is used to finance a crime, a civil court would declare the credit contract as nil and void. Contract law provides legal rules such as „void for illegality“ and principles of “good faith“ or “boni mores” to deal with such odious debts. This level of civilization achieved in private law has never been reached in international relations. If a sovereign state takes up an international credit to finance an aggressive war, an apparatus of oppression or to channel the money into the private coffers of office holders the rule of succession requires that a subsequent government has to honor the debt. This applies even if the creditor was aware of how the money was used and no matter what hardship this implies for the people in the debtor country. There are exceptions to this rule, which states treat like black boxes. After the Spanish Cuban war of 1898 independent Cuba was forgiven the debt from Spanish Government bonds, as they were odious as stated in the peace treaty between the USA and Spain. The same argument applied for German bonds used in territories, which became part of the new Republic of Poland after World War I. And after the dethronement of Saddam Hussein in Iraq creditors forgave most of their debts to Iraq under heavy political pressure from the IMF and the USA. However, these cases -regardless of how legitimate the outcomes may be- reflect not so much decisions based on the rule of law but more the distribution of power after a war. South Africa was not forgiven any of its international debts, even though some of the money financed apartheid and everybody knew it. South Africa after apartheid did not want to agonize creditors and a judicial routine to cope with the problem did not exist. When it comes to odious debts international relations are better conceptualized by an analysis of the Hobbesian state of nature than by a concept of law, based on fair rules and principles. Over the last decade the scientific community and especially scholars of law and economics have rediscovered this problem anew. It lay almost idle for about 60 years after a discussion in the 1920s on the legitimacy of the Soviet Union’s decision to cancel Czarist government bonds. Stephania Bonilla’s doctoral thesis is an important contribution to the current debate. She wrote it as a student in the doctoral law and economics program “Graduiertenkolleg Recht und Ökonomik” at the University of Hamburg. The research was financed by the German Research Foundation. Many of the issues discussed in this book in the context of odious debt are key issues, which will need to be addressed in order to move towards a more sustainable financial system, including ethics in finance and most notably, the issue of responsible lending and borrowing and finding solutions, which address the problem effectively without hampering the mechanism of international credit relations. Odious debt is also a timely topic as it touches on the complicit role of creditors and the issue of lender responsibility, while also raising the question about how to deal with repressive and autocratic borrowing governments who act against the interest of VI their people. These are timely issues particularly this year as the Middle East revolutions are taking place. Among other issues, one will see how new governments and regimes in these countries will deal with their past financial obligations. This book analyzes, why sovereign debtors generally tend to service their foreign debts, whether odious or not and how states consider their reputation in the sovereign debt field and in international law when making their decision. It looks at the incentives of parties and different creditors in distinct sovereign debt relations, and the implications that the incentive structures can have on reputation and odious debt. The book also provides an economic analysis on distinct facets of the odious debt issue, which are relevant for international economic governance as a whole. It looks at the players and the drivers of change at the policy level in the field of sovereign debt and in the current odious debt debate. It also deals with the question of whether an ex ante or ex post approach is more feasible to solve the problem efficiently. The latter would –as in private contract law- cancel an odious debt contract after a government has taken up the credit. This might lead to legal uncertainty for a considerable span of time and might negatively influence international credit. The former would legitimize an international body to declare future credits to a particular country as odious. It is obvious that the ex ante approach would impose the least legal uncertainty and not much disrupt international credit markets. The book is highly recommendable for lawyers, economists and political scientists working in the field. But it is also attractive for a larger audience interested in an important aspect of international financial relations. Prof. Dr. Hans-Bernd Schäfer Acknowledgements This book is the result of my research at the Doctoral College of Law-and-Economics (Graduiertenkolleg Recht und Ökonomik) of the University of Hamburg. My first acquaintance with law-and-economics began as a student of the European Master of Law-and-Economics (EMLE) and it paved the way for my PhD and my continued passion for the field. First of all, I would like to thank my thesis supervisor Prof. Dr. Hans-Bernd Schäfer, who initially provided me with the idea of writing on the fascinating topic of odious debt. I have witnessed and have been inspired by his passion for law-and- economics and his quest for learning. I am grateful for his continuing support, encouragement and excellent guidance. I would also like to thank the other professors at the Institute of Law and Economics, particularly Prof. Dr. Thomas Eger who provided me with support and encouragement throughout my time as a student and with helpful criticism at the PhD seminars where I presented earlier versions of my work. I would also like to mention my time working at the International Review of Law and Economics working with Prof. Dr. Claus Ott. My thanks go to the editors of the scientific series "Okonomische Analyse des Rechts" for giving me the opportunity to publish my thesis here. Writing a doctoral thesis is both an intellectual and an emotional journey, one which is undoubtedly more difficult without a good support group. My experience would not have been as rewarding if it weren't for the friendship and motivation of my fellow PhD students at the Institute in particular my officemate Tammy de Wright as well Jan Peter Sasse, Katherine Walker, Peter Cserne, Susan Russell, Jan Matauschek, Stephan Wittig, Henning Frässdorf, Frank Müller-Langer and honorary member of the Institute and friend, Lena Ekelund. I would further like to express special gratitude to Prof. Avery Katz and the University of Columbia for having hosted me as a Visiting Research Fellow in the Spring of 2008. I am indebted to Prof. Anne van Aaken for having listened to my presentations on odious debt countless times and whose positive criticism and enthusiasm have been invaluable. I am grateful for the comments that I received from Prof. Mitu Gulati, Prof. Eric Posner, Prof. P.G. Babu, Prof. Thomas S. Ulen, Prof. Thomas Ginsburg and Prof. Andrew Guzman on earlier drafts of my Papers. Of course, the opinions expressed and errors made are all mine. One of the best parts of doing research is to be able to share it and discuss it with others. I would like to thank participants of the law-and-economics conferences in Madrid, Copenhagen, Rome, Kassel, Prague and the summer schools in Gerzensee, St. Gallen, Corsica and our own Institute's Summer School in Law-and-Economics in VIII Hamburg. Special thanks to Ido Baum and Ohad Soudry for organizing an invaluable summer school experience at the universities of Haifa and Tel-Aviv in 2005. I acknowledge and am grateful for the generous financial support provided by the German Science Research Foundation (DFG) for my research both in Germany and the United States and for allowing me to travel and present it across Europe. Finally, I wish to thank my husband Greg, for his unconditional love, support and patience, particularly during the 4 years of long distance relationship during my studies. I wish to dedicate this book to my parents and my sister, who have never seized to inspire me, support me and guide me. Table of contents Foreword............................................................................................................................... V Acknowledgements.............................................................................................................. VII 1 Introduction................................................................................................................. 1 1.1 The traditional doctrine of odious debt.............................................................. 4 1.1.1 War debts............................................................................................... 4 1.1.2 Subjugation debts................................................................................... 6 1.1.3 Regime debts.......................................................................................... 7 1.1.4 A note on the doctrine............................................................................ 8 1.2 The literature...................................................................................................... 11 1.2.1 Legal proposals...................................................................................... 11 1.2.2 Other proposals...................................................................................... 13 1.3 Approach and outline of this book..................................................................... 13 2 Reputation and Odious Debt....................................................................................... 17 2.1 The Legal Approach.......................................................................................... 18 2.1.1 Legal Rationales to Succession of Obligations...................................... 18 2.1.2 Lack of Explanatory Power................................................................... 21 2.2 The Economic Approach................................................................................... 21 2.2.1 Why Does Sovereign Debt Exist?......................................................... 21 2.2.1.1 The Reputation Theory............................................................ 22 2.2.1.2 The Enforcement Theory......................................................... 23 2.3 The Comeback of Reputation............................................................................ 25 2.3.1 Incomplete Information and Changing Preferences.............................. 25 2.3.2 Repayment Record and Diminishing Returns....................................... 28 2.3.3 Context................................................................................................... 29 2.4 Implications for Odious Debt............................................................................ 30 2.4.1 Repayment Record................................................................................. 30 2.4.2 Context................................................................................................... 32 2.4.3 Default and odious debt......................................................................... 33 2.4.4 Repayment and odious debt................................................................... 35 2.5 Insights from the Economic Analysis of International Law.............................. 36 2.5.1 The Role of Law in the International Context....................................... 36 2.5.2 How law Implicates Reputation............................................................. 38 2.5.3 Interpreting the Law: The Odious Debt Doctrine is Dead..................... 39 2.6 Conclusion ........................................................................................................ 41