Some Latin American governments are increasingly questioning the 'legitimacy' of their public debt. Questioning the need to service and repay debt incurred by previous governments, despite having ability to pay, is an innovative strategy that aims to elevate the needs of domestic citizens by making additional resources available to them, at least in the short term.
However, it runs contrary to the rules and expectations underpinning the global financial architecture.
The government of Ecuador on December 12 declared the first debt default in Latin America since Argentina in 2001:
•The government decided not to make a 30.6 million dollar interest payment on its Global 2012 bond, having allowed a 30-day grace period to lapse.
•A similar payment, of 30.47 million dollars on its Global 2015 bond, looks like it may also be missed when its 30-day grace period ends on January 14, 2009.
'Strategic default'. Ecuador's current default is extremely unusual in that it is the result of a strategic decision by the government, rather than of the inability to pay. It is this strategic nature that makes the playing out of the case of Ecuador extremely important from the perspective of the international financial system:
•'Success'. If Correa's gamble appears to pay off initially, by seeming likely to succeed in substantially reducing his county's debt burden without a significant economic deterioration, this could embolden other governments in the region and elsewhere to make similar moves.
•'Failure'. However, if it soon becomes apparent that the cost of Ecuador's default is too high, in terms of a virtual elimination of (already reduced) access to international credit markets -- including companies' access to trade finance -- and an ensuing worsening of fiscal problems (probably including an inability to meet accelerated debt obligations even if it wished to), then this would be likely to discourage other countries from taking similarly belligerent approaches.
Failure is more likely than success, which is the main reason why such 'strategic defaults' have generally not been tried in the past. Nonetheless, there is a risk that a small number of countries -- including Argentina, Bolivia, Paraguay and Venezuela -- might follow Ecuador's lead in the near future in classifying some of their external debt as 'illegitimate'.
Wider reaction. There is certainly a significant degree of truth to the argument that debts incurred by previous authoritarian and/or corrupt governments in developing countries have not ultimately had the domestic social benefits expected. Some non-governmental organizations, such as the Jubilee Debt Campaign, have long sought to bring to wider debate issues surrounding the 'legitimacy' of developing countries' debt burdens and appear generally sympathetic to the idea of strategic default if the social burden of continuing debt servicing and repayment is very onerous.
In a worst-case scenario, the actions being taken by Quito and being contemplated by some other regional governments could embolden countries all over the world to engage in strategic defaults on their debts. Though unlikely, this could lead to the unraveling of parts of the global sovereign debt system, with dire long-term consequences. More likely is that Ecuador and any other countries pursuing strategic defaults will suffer severe economic collapses in the short-to-medium term, deterring other countries from doing so.