Domestic and External Debt: The Doomed Quest for Equal Treatment

Abstract

Until recently, governments borrowed from domestic residents and foreign investors using very different instruments. Residents bought "domestic debt" - paper denominated in local currency and governed by domestic law. Foreign investors preferred "external debt", which offered foreign currency and foreign law. Because there was virtually no overlap between resident and nonresident holdings, it mattered little that lawyers and economists defined domestic and external debt differently: lawyers focused on features such as governing law and jurisdiction, economists on the holder's residence and currency of denomination. The legal and economic definitions of domestic and external debt were effectively bundled: "domestic debt" meant local-currency, local-law instruments held by local residents; "external debt" meant foreign-currency, foreign-law instruments held by foreign investors. In the end, lawyers and economists spoke of the same paper. Liberalization of the international capital markets has changed this. Foreigners now routinely invest in local currency, domestic law debt, and residents often dominate international sovereign bond issues. With these changes, the legal and economic definitions of domestic and external debt have unbundled. This change in the pattern of sovereign borrowing demands a new way of framing the core issues that arise in a financial crisis. Most existing approaches focus disproportionately on one set of legal instruments: foreign currency sovereign bonds governed by foreign law. Our essay argues that this focus is misplaced. It is the product of an analytic prism that no longer reflects reality well enough to offer a useful guide to crisis management.

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