Of Default and "Default"

Ceci n'est pas splitting hairs
Ceci n'est pas splitting hairs
Ceci n’est pas splitting hairs

Consider “default”. It’s a tricky one: both an ordinary English word and a term of art with a specific, legal definition in the field of finance. There’s a reason why this ordinary word is used to label that legal concept: the two meanings usually map onto each other reasonably well. But not always.

Today, the debate about Venezuela’s shockingly mismanaged economy fell right into the space between one kind of default and the other.

In ordinary language, “default” just means failing to live up to your obligations. As a financial term-of-art, defaulting means “violating the provisions of a formal loan contract” – usually, but not always, by failing to pay back what you owe for a loan on time.

Here’s the thing: governments have plenty of financial obligations that arise from things other than formal loan contracts. The U.S. government, to give just one example, has a clear obligation to pay a certain amount each month to its pensioners, through the Social Security Administration. If one day the U.S. is unable to make that payment in full, people will certainly talk of the country “defaulting on its senior citizens”, and in the ordinary sense of the word they’ll be right, of course.

But that obligation does not arise from a formal loan contract. In a technical sense, failing to pay social security would not really constitute default. Not as the markets understand the term, anyway.

Now, think of Venezuela.

In their now famous piece, Ricardo Hausmann and Miguel Angel Santos argue the country is in default with pretty much every domestic constituency. And in the everyday sense of the word, that’s true: Venezuela is behind on its obligations to its cancer patients, to the airlines that connect it with the world, to PDVSA’s suppliers and everyone in between.

But we should be clear, when financial economists use the word “default” in this broader, ordinary-language sense they’re at best engaged in a bit of an intellectual provocation. At worse, they might be seen as openly courting misunderstanding.

The reality is that, in Venezuela, just about the only group the government still pays on time is…the holders of bolivar denominated bonds. The guys (or, well, the banks) holding DPN bonds and Letras del Tesoro, keep collecting their coupons like clockwork. The interest on those coupons may be way behind the rate of inflation, but that’s still better than many alternatives. (They don’t call it “financial repression” for nothing.)

This means that, in the technical sense that’s relevant in market terms, Venezuela is not in domestic default.

Yes, Venezuela has a strange situation with bolivar holders who’ve applied to CADIVI/CENCOEX to buy dollars and have had their requests “approved” at one rate but not executed for years. In some cases, the execution has come at a higher rate than the original approval.

But let’s be clear: an AAD is not a debt contract. It can’t be traded, isn’t really negotiated, it’s just not a bond. There’s zero jurisprudence for treating failure to honor an AAD at the original exchange rate as default in the legal sense.

Just the opposite: the exchange rate risks inherent in investing in a country with a non-convertible currency have been baked into investment decisions regarding Venezuela for more than a decade.

In the Venezuelan context, failure to discount your paper profits by the expected probability of devaluation before you get a chance to repatriate them amounts to dereliction of duty on the part of an MNE executive. If it’s not a firing offence, it ought to be.

Everybody’s known this is the deal for years: under conditions of very limited competition, you get to pile on bolivar profits ad infinitum, but you do so in full knowledge that those profits are de mentirita, contingent on an enormously iffy “if” that has the CADIVI logo stamped all over it. When you take a risk like that and it goes bad, it’s the height of churlishness to call it default: you just took a risk you understood perfectly well ahead of time and it didn’t pan out. That’s all.

So this is my first bone to pick with Reinhart and Rogoff’s Project Syndicate piece: they’ve just mixed up their defaults. They have a pile of research about what happens to countries in domestic default, and they use it to make a prediction about a country that’s not, legally speaking, in domestic default. That in itself is pretty shocking for a pair with better reason to be extra-scrupulous about the details than most.

But the bigger problem with R&R’s piece is that it begs the question: it just presumes that the reason Venezuela is failing to meet all its domestic obligations is that it’s insolvent. In normal circumstances, you might reasonably conclude that. But Venezuela’s circumstances are anything but normal: we have the world’s most misaligned foreign exchange rate. The split between the official and the parallel exchange rate is now 13-to-1!

This is the crux of the Great Venezuela Macro Debate of 2013-2014: to what extent can the government’s failure to meet its domestic obligations be ascribed to a basic inability to pay, and to what extent is it just the Nth insane distortion you get when the government makes it illegal to pay a penny more than 77 cents for a $10 bill?

Alas, in discussing Venezuela’s ordinary-language-default, Reinhart and Rogoff never refer to exchange rate misalignment at all. That’s a bit like writing about the sinking of the Titanic without mentioning the iceberg.

Starting with their conclusion and failing to engage the meat of the discussion, they just don’t seem very familiar with the specifics of the macro debate Venezuela-heads have been having for the last couple of years. It’s really unfortunate.

But I really feel I need to be on record here: that OpEd is awful.