The “Sovereign Debt Sanction”: How monetary policy can be used as foreign policy

By Ramon della Torre
Compliance Specialist

Targeted financial sanctions often induce political instability in the targeted state by impairing those financial means deemed necessary to successfully fulfil the very same policies which prompted the imposition of sanctions in the first place. Irremediably, sanctions impose costs (often in terms of restricted trade and financial losses) not only on the target, but also on the very same states that imposed them.

The costs of sanctions depend on the degree the involved parties are interconnected. The more the parties are interconnected, the more the costs associated to sanctions are shared. The recent case of the EU sanctions against Russia offers an example of how the sanctioning countries suffered (until the time of this writing) economic losses and were exposed to more geopolitical risks directly stemming from the imposition of sanctions.

An example of the distributional consequences of sanctions on Russia by EU member states. Source: The New Deterrent? International Sanctions against Russia over the Ukraine Crisis

In this post, I would like to consider the implications of a new type of sanction – the “sovereign debt sanction” – aimed at imposing directly on the government to be sanctioned pre-defined financial constraints. These constraints on the targeted state would be in the legal form, of a stay on all of its financial claims related to payments due on foreign sovereign debt securities (i.e. bonds issued or guaranteed by the government of a foreign country). These bonds are always detained within foreign-exchange reserves, which broadly constitute the public treasury of a state.

The proposed legal stay shall prevent the target from selling in the secondary markets the foreign bonds it already owns or demanding the payment of the underlying debt at its due date. This sanction could even lead to the forfeiture of some of the target’s financial claims on foreign bonds, thus relieving selected countries from a part of their debt towards the target.

This measure (whose value can be precisely calculated upfront) would directly prevent the target from acquiring the necessary resources to finance its stated goals, unless it has access to more expensive (if available) form of credit or cut its public spending. That is why in the context of a conflict, when access to credit is otherwise restricted or prohibitively expensive, foreign sovereign debt securities become vital means to raise financing. This is often the case when governments need to run deficits connected with aggressive monetary or fiscal policies, required to offset financial crises or political turmoil, which can be the consequences of any international dispute independent from the eventual sanctions.

…when access to credit is otherwise restricted or prohibitively expensive, foreign sovereign debt securities become vital means to raise financing.

Frequently in the hardship that countries face when targeted by sanctions, the government needs to successfully and quickly reach its promoted goals to sustain the necessary domestic support to maintain power. Hence, the impact that the proposed sanction might have on the treasury of the targeted state would be so immediate that the target might not be able to reach its goals. This outcome can be equated to a measure of the success of a sanction.

Furthermore, implicitly connected to this type of sanction is the debt relief which will benefit the states either directly involved in the conflict against the target or taking part in the group of states imposing the sanctions. Consequently, the sanctioning states avail themselves of the financial resources (often vital during the hardship of a conflict) that otherwise should have been transferred to the targeted state.

A central government’s external debt, which is often detained by national and international monetary authorities and institutions, can be a powerful instrument of foreign policy, granting to sovereign creditors significant power over the sovereign debtors. Yet sovereign debt securities as an instrument of foreign policy to mitigate or even stall conflicts have been very much underestimated until now. This is probably the case because of the possible complex financial spillovers as well as the legal constraints due to the conflicting interests among pivotal global financial centers competing to attract foreign capital.

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