Explainer: What’s the Big Deal About Default

Wondering why exactly economists are so freaked out about a possible default? You're in luck. Here's a 100% jargon-free Explainer anyone can understand.

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People have credit cards. Countries have bonds.

Credit cards are really useful. Sometimes you need to buy a big-ticket item, a washing machine or a car, and you just don’t have the whole sum up front. Sometimes you’re just a little bit short of cash one month, but you know you’ll be good for it soon. So you borrow. And you pay it back over time. It’s normal. It’s fine. 

 
You don’t even realize how much everything you do depends on credit until you can’t get any.

Countries do the same thing with bonds. When they need a big-ticket item and can’t afford it all at once – a major refinery, say, or a new highway – or when they’re just a bit short, but they know it’s temporary, they print up IOUs, sell them to whomever wants them. If all goes well, they then pay back those IOUs – with interest – when they come due. That’s all a ‘bond’ is, really – a way to borrow. It’s normal. It’s fine.

But sometimes people aren’t careful with their finances, or their circumstances change, or both. Suddenly they have more credit card debt than they can afford to pay back. And when that happens, it’s not fine. Actually, things can get really unpleasant pretty fast.

Fail to pay your Credit Card bills and your credit rating tanks. And once you have Bad Credit, you just can’t borrow anymore. Nobody will lend to you. This makes life really complicated. Unmanageable in some ways.

You don’t even realize how much everything you do depends on credit until you can’t get any. When you go to get a cell phone and you see that alluring “$0 for a Samsung G5 with a two year contract” offer, it’s not immediately obvious that that’s a credit deal: they’re loaning you the money for the phone and you’re paying it in monthly quotas over two years. Bad credit? Forget about that G5.

Bad credit, means living in a Cash Up Front economy.

And that’s not all.

On some loans, you put up collateral. And if you miss your payments, the guy who lent the money to you can pay himself back by calling the Repo Man and just grabbing your collateral. They can do it with your car, sure, but not just that. They can go to a judge and tap right into your bank account.

Scale that up to country level and you start to get a sense of why economists are so freaked out that Venezuela (or its mini-me, PDVSA) might default on its bonds later this year. If you think it’s awkward for one person to get by without being able to borrow – and it is – it’s 30 million times more awkward for a country. If you think access to food and medicine is bad in Venezuela right now, just wait until the country just can’t transact abroad anymore.

 Every interaction between Venezuela and the outside world has a credit component. Without credit, Venezuela is North Korea.

At country scale, there are zillions of analogues to that $0 Cell Phone example. In the world of international commerce, credit is king. It’s everywhere. We’re talking about all the imports, not just the ones you’re thinking of (food, medicine) but also the ones we tend to overlook (spare parts for printing equipment for packages for supermarket products, refinery components, chemicals to treat drinking water, and an enormous, unfeasibly huge etc.)

And imports are more than just things. Want to make a phone call to your friend in Panama? CANTV will have to make a payment to the Panamanian telecoms firm that receives the call, and you can bet there’s a credit component to that contract. Want to fly abroad or watch foreign TV via satellite? Credit is woven right into the service economy in millions of ways you can’t always see.

One way or another, every interaction between Venezuela and the outside world has a credit component. Without credit, Venezuela is North Korea.

And that’s not all. There’s also the Repo Man.

In PDVSA’s case, it won’t be a dashing young Emilio Estevez taking our stuff – it’ll be an army of very ridiculously overpaid New York lawyers.

If PDVSA doesn’t pay its bonds this year, lawsuits are going to start to rain down. The Armani-suited Repo Men are likely to try their luck at just about everything: tankers leaving Venezuelan ports full of oil, yes, but also the bank accounts where Venezuela is paid for those tanker loads. Citgo refineries abroad. That Russian bank Fonden half-owns. Pretty much anything Venezuela owns abroad.

 
Venezuela’s economy is too screwed up as it is to withstand any more shocks. And a credit event would be a big shock.

Of course PDVSA has overpaid lawyers of its own, so it’s going to be a fight. If you know your car is about to get repoed because you didn’t pay your installments, you might try to hide it. Put it under somebody else’s name. Paint it. Change the license plate. Get creative!

Thing is, you can be sure the guys you owe money to won’t just take that sitting down: you’re going to get dragged to court, and it’s going to be messy and slow and drawn out and expensive. And while you’re tied up in three dozen court cases, who’s going to want to do business with you?

The one-two punch of losing access to foreign credit and facing a tsunami of lawsuits from international Repo Men is terrifying. Venezuela’s economy is too screwed up as it is to withstand any more shocks. And a credit event would be a big shock.

The thing is, the key cabinet players – Del Pino, Pérez Abad, Marco Torres and co. – seem to grasp the scale of the calamity default would entail. That’s why it was an important signal when they managed to get Luis Salas – who didn’t grasp it at all – kicked out of the cabinet. They wanted to show they get the danger default poses. They are, in a way, desperate to pay.

Even the people they owe money to are staggered by their determination to pay. They’re going to beg, borrow or steal every last penny they can in the quest to keep paying. That has horrendous implications for the nation in the medium to long run, but they’re not thinking beyond November. They know if they don’t pay, the sky caves in.

But can they?

We’ll find out.

 

25 COMMENTS

  1. Quico – you glossed over an important point. Individuals and governments would be best advices to use debt for funding capital projects (investment) i.e. Infrastructure, Hospitals, Schools in the case of governments, a house/ university degree / medical preventive treatment. As things happen debt is abused and used by both govvies and people to fund: current consumption. THat’s when it all goes horribly wrong…..

    • Of course, I gloss over all kinds of things: it’s an explainer! But I actually dispute this. I think it’s well established that consumption smoothing is an important function of credit.

      When your income falls temporarily, the smart thing to do is not to reduce your consumption by tomorrow the difference until your income and proof again. The question is whether the oil shock is temporary or permanent.

    • Venezuela’s problem is actually a bit different. The problem is WASTE.

      To really extend the analogy, we’re like a consumer whose finances are stretched to the limit, but when you look at the specifics of what they’re spending on, it turns out 2/3rds of their budget go on power bills. Investigate further still and you realize they live in an incredibly cold country, have the heaters on at full blast all day and night….and all the windows open. And they’re pawning the family’s stuff to pay those power bills!

      Güebón, cierra la ventana! Quit subsidizing gas and foreign exchange! You’re going bankrupt paying those bills!

  2. I’m very curious about something, Quico. Your analogy between people and countries breaks down when you acknowledge the fact that “Venezuela” is not a standalone entity, but a human organization managed by people. In this case, by deeply incompetent and irresponsible people.

    What happens when a government goes deep in debt and the next government refuses to honor previous obligations? Is there a way out?

    If I fail to pay my credit cards this year, I’m still the same person next year, and should be held accountable. Venezuela? Probably not.

    • Look, there are arguments on both sides. The next government can – will – try to argue debts incurred without AN agreement are illegal. Creditors will of course disagree. Sooner or later, it’s going to end up before a judge.

      In other words, this is the kind of question that will, sooner or later, translate into TONS OF MONEY IN FANCY NEW YORK LAWYERS’ POCKETS!

      Los únicos que ganan con esto son los abogados…

  3. Very clear explanation of the mechanisms of commerce and the extent of credit. It’s a stark explanation which makes the point obviously visible without getting mired in technicalities and contracts. Really good.

    Most people sum it up too simply with blanket statements like “Country credit ratings affect everything the country does,” and that doesn’t explain sufficiently. Or the explanations try to draw attention to each of the arms of an octopus, without ever making the connection to the octopus itself, and that’s too complex. .

    Specific to Venezuela, it stuns me that the government with its “nationalistic, centralized” policies persists in making things worse. The government hand in all this affects the consumer level, the importation of basic goods and raw materials which impact the population. If you do business with XYZ grocery store company, or consumer appliance retailer, in any country, and know they pay their balances, you don’t care about the national debt there. The company is independent, and has its own credit rating. But when the “government” interferes with operations, places restrictions on imports and sales, or outright expropriates, that links the company to the government, then the country credit becomes an issue. The Venezuelan government insists on replacing competent management with their own incompetent management, as if they were doing the right thing. Stunning.

  4. Excellent explanation , very clear , simple and understandable …….of course it misses on a lot of details but if you go into the details the explanation then becomes less clear , less accesible to ordinary folk not too well versed in economics so better not to get into the itty bitty details ….

    One important point to make is that what makes default really awful for Venezuela is not that the country should default (Argentina defaulted and spent years in default) but that Pdvsa should default because we are as a country totally dependent on our oil revenue and if the later falters everything goes to the dogs . Pdvsa is the main sources of international income and if a default of pdvsa should ocurr there will be a dozen ways its creditors can play havoc with its offshore income , accounts and the assets it must buy and import simply to keep operating (not to mention its dependence on marketing channels like Citgo) .

    Precisely Venezuelas problem is not that the Republic is in the throes of becoming unable to pay its bonds because these dont really become payable in the next years , instead its the fact that for the next 2 years quite a few Pdvsa bonds fall due and if you do your arithmetic it doesnt seem to have the money to pay them which would almost certainly involve a default …….

    If Venezuela were not so dependent on State owned Pdvsa the situation would be bad but easier to manage …….unfortunately thats not the case ……..and Francisco’s take is true , the govt is desperate for Pdvsa not to go into default and will do most anything to pay its bills , even if we all have to starve for it ….!!

    • Yeah, I considered editing it to say that for PDVSA to default would be like for the only person in a household of 12 who has an actual job and an actual income to get bad credit and have his wages garnished. But I didn’t want to enredar the explanation.

  5. Great post. A very illuminating explanation. I agree that a default could be devastating for the already dire state of the Venezuelan economy. I don’t agree in a couple of points: through the commercial external default Venezuelan companies and the government have already incurred it is like they had already defaulted, so not much extra cost there…they are in a cash upfront basis right now. This takes me to the second point on the seizing of assets: all that is taking the default decision from happening is a group of those New York lawyers to convince the government they can shield (even temporarily) those assets and kick the can down the road for maybe a couple of years and maybe paying 100% then.
    I think the government’s strategy is to show that they can continue paying and they must be befuddled why those yields do not come down and allow them to re-finance the debt that is maturing in the next two years. How long can the economic team continue convincing Maduro that the opportunity to re-finance is coming just if they make the next bond payment?
    In the meantime, it is sad to know that one of the reasons that some analysts expect the bonds to continue being services, with all the human cost that is taking” is that “connected individuals” are also holders of those bonds.

  6. An excellent “explainer!” First, Venezuela has already defaulted on their lines-of-credit from thousands of companies from around the world, airlines, auto spare parts, pharmaceuticals etc. They owe, what, 25 billion +…? Second, past financial shortfalls were usually met with someone shouting ‘road trip!’ at Miraflores, whereby everyone would gather their papers, trundle down to the waiting Cubana Airliner and fly-off to Beijing. Er, ah, no Chinese take-out this time. Third, a giddy Merentes announcing to the world a new loan for Venezuela (pause here for the expected applause), from the Gold Reserve deal, is usually a sure sign of the final stages of ‘debt dementia.’ Everything is believable, miracles are just around the corner. The problem, of course, is that no one in their right mind would lend these clowns any new money with a credit score like, …that.

  7. FT, a truly good layman’s explanation of some of the problems of default. What is really mind-boggling is that this irresponsible/incompetent Govt., in the face of myriad consumer/industrial scarcities, still plans to purchase some $4 bill. in military equipment, and finance/give away oil/other to the Chulo Alba nations, so that, for example, they can send representatives to Venezuela to celebrate the 3rd anniversary of the “Siembra” of El Inter-Galactico mostly resonsible for Venezuela’s looming default.

  8. The whole situation is crazy the key denomitaror is INACTION. This situation should have been addressed a long time ago but “la raya” of having to apply economic reforms is too big. Their strategy is Hope. “Hope that oil prices will come back again”. Regardless, they will need to make economic reforms to make the country viable again. Politics can no longer drive Policy.

  9. Two things: great primer piece, should be translated to Spanish for larger distribution, second, perhaps in the Spanish piece, try to add a more relate-able analogy for credit for other audiences, like “anotamelo ahi” at the corner store or bodeguita.

    Large parts of the Venezuelan population have other experiences with credit than a bank issued credit card. We are taking fiado, apartado por cuotas and the like.

    Also would like to see some content on the relationship of credit and inflation! and how the hyperinflation slide to hell is also going to hurt any credit transactions in bolivares “fuertes” (sic)

    Thanks Quico very useful piece. The one type we need to explain complex issues in lay terms.

    • Let’s hear more about how greeks did “just fine” with default.

      It has been a common secret among PE teachers for some time now that they don’t expect pupils to do PE any more, because many of them are underfed and get dizzy.

      They need to be discreet, as these underprivileged children don’t wish to be exposed to their peers. In my previous school, the teachers arranged among themselves to give the school canteen some money, so that the canteen could give the child a snack, without embarrassing the child.

      However, this was not enough. In many schools today, it is the parents’ associations who come together, gather food and discreetly arrange to allocate it to those families of the school who are suffering. In co-operation with the teachers, they know which children in the school are hungry and in need of help. Again, they try to do it as discreetly as possible.

      “Many families, suddenly left without work, are in shock and there is nowhere to turn. Social services are collapsing. They are not professional beggars. They are ordinary people like you and me, suddenly left with nothing. I know one area, where schools have specialised in what they gather: 1st primary school gather rice and legumes, 2nd vegetables, 3rd meat and chicken etc.

      • I don’t think it’s a nit. If you’re far enough away, if you’re not the one going to bed at night hungry year in and year out, it’s easy enough to say “well, it’s not really that big a deal.” But there’s incredible hardship swept under the rug in that move.

  10. Somebody, please, explain how Cuba has survived so many decades? Their exports were sugar, cigars, and communism! Isn’t this what was intended all along?

  11. Sigh…Good analysis although somewhat missing the bigger picture. A large number of developed economies are running on fumes with regard to their finances. This doesn’t justify reckless behaviour by Venz/PDVSA but it is a key point when discussing ratings,value, etc. Everything needs to be assessed in the context of relative value and this is what people never seem to understand. No one notices things until shit hits the fan. Classic example: Greece. Rated AAA for many years (by the same rating agencies with ZERO credibility in the market like Poor Standard who have given Venz/PDVSA bad ratings). Pension funds in many developed economies are severely underfunded, liabilities of insurance companies are usually bigger than they can afford to pay, etc. This is why some people are compelled to buy Venz/PDVSA, because the wealth that is underground, even if it’s difficult to extract and is of little value at the moment, gives a more asset-rich argument in the long run than when buying say a Spanish govt. bond for example, a country that is dependent to a large extent on market interest rates (a few percentage points up and they are toast) and with a very heavy cost structure to maintain. Hence, Venz/PDVSA is a strong buyyyyy. Yeehaw! Buckle up!!

  12. This only marginally applies to a Chavista led government. An opposition led government could call it an Odious Debt and repudiate the bonds tying any payment up in court for years, and if you win you not only not have to pay but set a strong international precedence to the financial community that if you lend to dictators you’re not getting it back. The real reason the government wants to pay is because they own so many of the freaking bonds from the PDV pension fund and other vehicles.

    I don’t buy the default boogeyman being a terrible outcome. Look at countries like Argentina and Ecuador, the effects of defaults on their economies where marginal when compared to all the turmoil a country like Greece has gone through to avoid default.

    If the opposition takes power on Day 1 they should repudiate the bonds while at the same time offering to hand back expropriated companies with certain restitution to their original owners. Make it extremely clear to the international community that you are pro-business and will honor business contracts, just not debt brought on by dictators. People who had companies expropriated didn’t have a choice, those that bought the bonds did.

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