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Unless you’ve been living under a rock for the last year, you would have no doubt seen the revolving door of news surrounding Trump’s Trade War with China. I won’t bore you with the well-known facts (see image below), but rather, hone in on a peculiar piece of this interesting puzzle.
Our story begins in May 1911. The Qing Dynasty, who had been facing a number of challenges to its rule, issued bonds to finance development of the Huguang railway in Central South China. During this period, China was similar to the ‘emerging markets’ of today, so as you can imagine, debt had to be issued with very favourable terms to the lenders in order to secure investment. Unsurprisingly, these particular bonds were issued with terms such as revenue sharing and high interest.
Under normal circumstances, these unfavourable terms would not be accepted by China, but the powerful Dynasty experienced a troubling 100 years between 1800-1900 and they desperately needed financing to develop their country.
During the 19th century, the Qing Dynasty dealt with everything from poverty and rebellions, to pressure from foreign armies and a burgeoning population. They also had to deal with a fiscal crisis, largely caused by the rapid population growth, coupled with their archaic tax system, which at the time, was fixed at low rates. There were additionally a number of notable events throughout this century, including:
– The Opium Wars: Two wars between the Great Qing and the British Government, specifically regarding China’s opium trade. These wars and subsequently imposed treaties impacted the Qing Dynasty and Chinese government substantially, forcing them to increase imports from imperial powers.
– The Taiping Rebellion and Dungan Revolt: This occurred in Central Asia and ultimately led to the deaths of an estimated 20 million people at the hands of famine.
– Sino-Japanese War: Fought between China and Japan, this war saw the Great Qing lose influence over Korea and notably, its possession of Taiwan.
The bonds were popular with investors in more established economies, like the US, and according to some estimates, approximately $2.5 billion of foreign capital (nominal terms) flowed into China before 1938.
What happens between 1911 and 1938 is where the story gets interesting. Toward the end of 1911, a group of revolutionaries led a successful revolt, ending the Qing Dynasty and putting in its place, the Republic of China. What followed, was more turbulence for China, one that included a civil war between the Republic and the Communist Party, World War II and eventually, the official establishment of the People’s Republic of China (PRC) in 1949.
During these difficult 38 years, 1938 and 1939 contained two pivotal moments regarding the bonds.
– 1938: Most of the bonds that were issued in 1911 were in default.
– 1939: The Republic, who repudiated the debt, stopped paying interest.
Repudiated debt and lessons from Mother Russia
Leading up to the 19th century, repudiations were common and according to Wells and Wills (2000), history showcases various examples where Sovereigns have reneged on their debts. However, governments typically avoided the repudiation of international debt, as they feared the consequences.
A great example of this was when the Soviet Government, in February 1918, repudiated the debt incurred by the Tsarist government. Following this, the Soviets expropriated all foreign nation assets in Russia and nationalised banks and land, restoring them to the national estate. This action shocked the international finance community and resulted in the country being condemned – the biggest losers were the British and the French.
You see, simply walking away from your debt and pretending it never existed, leaves a lasting impression…especially on your creditors. The French Minister of Foreign Affairs summarizes how the French felt about the repudiation, stating:
“We cannot accept as a right the repudiation of its debt by any country (…) otherwise no country in the world would be able to issue an international debt if a simple change in the government could annihilate the liabilities taken by the Nation.”
Governments typically try to re-negotiate their debts and find a way to pay them back, for fear of being locked out of international capital markets. In terms of consequences however, there’s a difference between defaulting on debt and repudiating debt.
Consequences of repudiating debt
Understanding the direct consequences of the Soviet Government’s repudiation of the debt incurred by the Tsarist government is difficult because it was part of a much bigger picture and historical event, World War 1. However, the repudiation itself did have a large impact, particularly on the French, who were hostile towards the Soviet Government, because they were the largest holder of Russian Bonds and were fearful that the revolutionary movement would spread to France.
Considering the various complexities of the Great War and the Soviet’s actions, the consequences were severe. From 1918, the Allied powers led an economic and financial blockade against Soviet Russia. Russia attempted to import goods and pay for them in gold, however major banks and governments of the world wouldn’t accept the Russian gold, as to do so, would mean they were disregarding the blockade put in place by the Allied governments. Paris, London, Washington and Brussel all declared they had a right to the Russian gold as they were debt holders of the Tsarist bonds – as you can imagine, this impacted the Soviet Government’s trade severely.
Interestingly, France managed to recover a large amount of Russian gold in November 1918 as Germany capitulated (Berlin had originally received the gold from Russia in application of the Brest-Litovisk peace treaty signed in March 1918). France refused to return this gold, stating that it was part of the reparations Germany owed Paris.
Consequences of governments defaulting on debt
You’d think that defaulting on sovereign debt would have serious ramifications with respect to accessing capital in international markets and indeed it can, but a closer look at the available evidence suggests mixed consequences. According to Eichengreen (1991), it hasn’t necessarily been easier for countries that didn’t default in the 1930s to gain access to international capital markets. However, there is evidence showing that defaulting on such debts has led to shrinking capital flows, as international lenders shutting the door.
Typically, the defaulting country will experience a rough period of austerity, in which they deliver policies aiming to reduce budget deficits. Think, spending cuts, tax increases, a devaluing of the local currency all done with an attempt to boost exports and repay debts. A more recent example comes out of the GFC, when Iceland sharply cut its spending after it led its three major banks – Kaupthing, Glitnir and Landsbankinn – to failure. More than 50,000 citizens lost their life savings and its local currency collapsed 60% (between 2007-2008) – something that allowed it to become more competitive, and ultimately help return the country to economic stability and get access to international capital markets once again.
Typically, debts will also be restructured as lenders do what they can to help the defaulting country pull themselves from financial distress. After all, it’s in their best interest to ensure they succeed, for the hope that one day, they might receive their debt repaid in full.
Unsurprisingly, Trump has begun exploring these century-old imperial bonds, seeking to understand if the US can hold China to account on this un-paid debt. China argues that the debt is ‘odious’ and therefore, it should never be paid back. This concept of ‘illegitimate debt’ was founded by Alexander Nahum Sack, a Russian émigré legal theorist, who developed the concept with the intention that it should be used as an alternative to trade sanctions, specifically to eliminate the incentives of creditors colluding with dictators, who may issue loans to enrich themselves. This strategy also sought to be self-enforcing and would ultimately help pressure dictators to change their ways, so they can access credit. Most importantly, this would protect the citizens of a country by freeing them of the typical obligations involved with debt – repaying it. Unfortunately for China, ‘odious debt’ is an un-tested concept and there are little to no precedents.
The closest this concept got to coming to light was back in the late 1990’s, when a global campaign was launched which attempted to call attention to the concept and more broadly, the cancellation of debt incurred by developing countries. Interestingly, the spokespeople for this campaign, the Jubilee 2000, were Bono and Pope John Paul II. The campaign garnered little momentum in international law, which as it stands, continues to hold countries responsible for repaying their debts, even if it is illegitimate.
So that begs the question…should China have to pay back its century old bonds?
President Trump, US Treasury Secretary Steven Mnuchin and US Commerce Secretary Wilbur Ross certainly think so, and they have started meeting with bondholders and their respective representatives. The most well-known representation is Jonna Biance, co-founder of the American Bondholders Foundation, which was formed to represent holders of pre-communist debt and by her estimates, more than $1 trillion is owed by China.
Who knows where this will lead, but I can assure you, holders of these defaulted China bonds will be pulling them from their basements and dusting them off in hopes that one day, China will make good on its debt obligations.