Russia, sovereign debt defaults, and fiat currency

I have said on a number of occasions that a sovereign nation that issues debt in its own fiat currency cannot default involuntarily.  The case most people point to as a counterfactual is Russia in 1998.  I mentioned Russia in a recent post:

Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.

I was on a trading desk that was dealing in synthetic GKOs before Russia defaulted in 1998, so I remember the incident quite clearly. Russia’s was not an involuntary default by a country which issues debt in its own fiat currency. Russia was a perfect example of a voluntary default due to huge foreign currency debt and foreign exchange reserve losses (see Wikipedia for a pretty accurate and thorough account on the events of the 1998 Russian financial crisis).

Marshall Auerback summed it up well in an email to me as we discussed this case in view of his post refuting chatter about Japan defaulting. Not the underlined words.

Russia didn’t have to default.  As a point of logic, the concept of ability to pay being inherently revenue constrained is not applicable to the issuer of a currency. Any such constraints are necessarily self-imposed (including various ‘no overdraft’ legislation in some countries for the Treasury at the Central Bank). The issuer can always make payment of its currency by crediting the appropriate account or by issuing actual paper currency if demanded by the counter party.

An extreme example is Russia in August 1998. The rouble was convertible into $US at the Russian Central Bank at the rate of 6.45 roubles per $US. The Russian government, desirous of maintaining this fixed exchange rate policy, was limited in its willingness to pay by its holdings of $US reserves, since even at very high interest rates holders of roubles desired to exchange them for $US at the Russian Central Bank. Facing declining $US reserves, and unable to obtain additional reserves in international markets, convertibility was suspended around mid August, and the Russian Central Bank has no choice but to allow the rouble to float.

All throughout this process, the Russian Government had the ability to pay in roubles. However, due to its choice of fixing the exchange rate at level above ‘market levels’ it was not, in mid August, willing to make payments in roubles. In fact, even after floating the rouble, when payment could have been made without losing reserves, the Russian Government, which included the Treasury and Central Bank, continued to be unwilling to make payments in roubles when due, both domestically and internationally. It defaulted on rouble payment by choice, as it always possessed the ability to pay simply by crediting the appropriate accounts with roubles at the Central Bank.

Why Russia made this choice is the subject of much debate. However, there is no debate over the fact that Russia had the ability to meet its notional rouble obligations but was unwilling to pay and instead chose to default.

Russia defaulted voluntarily, an event which the geniuses at Long-Term Capital Management failed to model correctly. Moreover, the immediate stress on Russia was not the rouble-denominated debt but the mountain of foreign currency obligations via an unrealistic currency peg which were draining reserves. Similar events unfolded in Argentina a few years later as their currency board crumbled and the Peso was devalued by three-quarters.

Again, the point is that a government can always make good on its own fiat currency obligations if it chooses to do so. The real question is why a country might voluntarily default on its own currency debt or involuntarily on foreign currency debt.  The answer usually has to do with taxes.  In Argentina and Russia, the government was unable to prove that its taxation policies were benefitting its citizens, creating rampant tax evasion, especially in the monied classes. Capital flight took form as many dodged taxes. Capital flight eventually turns into currency revulsion which creates the pre-conditions for depression, as Latvia, Estonia and Lithuania learned most recently.

The relationship these examples from the Baltics, Argentina and Russia have with Japan and the United States is taxes. When taxes seem unfair or excessive, the citizens evade taxes and eventually revolt; you end up with a situation like Russia circa 1998, Argentina circa 2002 or Zimbabwe circa 2007.