It’s all about reputation. That’s the argument Stanford professor Michael Tomz makes – and credibly supports – in this 241 page work. Released in 2007 before the financial crisis, Reputation and International Cooperation: Sovereign Debt across Three Centuries is a serious but readable academic study of sovereign debt that says a lot about how sovereign loans are valued.
Of course to a seasoned banker, saying that reputation is the key to underwriting loans is trite.
But in the world of sovereign debt, where finance intersects with the maze of international politics, reputation’s preeminence in explaining creditor decisions can be obscured by a smokescreen of other theories. Tomz covers several of these perspectives, including the availability of enforcement measures like military threats, loss of trade, and collective creditor retaliation – and systematically dispels them through a methodical analysis of qualitative and quantitative historical data.
Tomz uses an empirical analysis of military disputes and financial relationships to refute beliefs that military intervention is a potential consequence of sovereign financial default. He also persuasively disputes that an oft-cited 1902 British intervention in Venezuela is a true historical precedent for intervention following default by showing that the British intervened primarily because Venezuela ransacked British residents, not to avenge jilted bondholders.
To show that reputation is superior to the threat of trade sanctions in explaining why sovereigns pay their debts, he reviews the case of Argentina in the early 1930’s. Argentina owed money to Britain, its major trading partner, as well as to the United States. Because, Tomz hypothesizes, the British bonds were less costly to service, Argentina could have easily defaulted against the U.S. – with which it had far less trade – and focused on paying the British debt. Instead Argentina implemented exchange controls that discriminated against British exporters to service its American debt, preferring to bolster its overall financial reputation at the cost of irritating a major trading partner.
Relevance to Investors
In setting up his reputation theory, Tomz divides countries into three categories: “stalwarts,” “fair-weathers,” and “lemons.” Again, to an experienced banker, this may seem like old hat.
However, of particular interest to today’s investors, Tomz’ establishes that the period when the conduct takes place is relevant. In other words, it’s one thing to pay back loans during a multi-generational run of prosperity, but quite another to maintain a sterling credit record when the financial world is collapsing. He cites in particular Depression‑era examples of Argentina, Australia and Finland, which surprised the world by paying their loans through the Great Depression, delivering them much more favorable interest rates in the years that followed.
If Tomz is correct, the current post-crisis environment provides a rare opportunity for “fair-weather” and “lemon” countries to vault into higher categories at a faster pace than ordinary times if they keep their payments current. Consequently, investors who correctly gamble on the debt of shaky countries may have more to gain than usual and faster – if they make the right call. While this prospect may obviously be relevant for countries like Greece and Ireland in widely publicized distress situations, it may also signal the prospect for nations long regarded as risky to increase their standing by quietly servicing their debt throughout the crisis period. Time will tell.
What the Book Does Not Answer
While Professor Tomz does an outstanding job of addressing questions within his scope of inquiry, his analysis focuses on the debts of nations that were not economic leaders. Consequently, the volume does little to address the credit of market-making nations.
Historical case reviews of Argentina, Australia and Venezuela – none of which were financial centers in the time period covered – and broad statistical evaluations do not provide any special insight into how far and long the United States and today’s other triple-A rated countries running large deficits can push their balance sheets. The special issues concerned with the credit of the wealthiest debtor nations will have to be addressed another day.
Reputation and International Cooperation is an excellent book for anyone interested in investing in sovereign bonds, or in financial history generally. Tomz blends a mix of colorful history with serious academic methodology in a way that is enjoyable for the general interest reader. Although the volume does not confront the thorny question of how far the richest nations can stretch their balance sheets in times of financial distress, it provides a fresh array of historical tools and perspectives for investors to consider the risk/reward ratio of sovereign debt opportunities.
Disclosure: The author holds investments in U.S. Government securities. The author does not hold investments in other sovereign debt as of the original publication of this post.