What Happens to the National Debt After Secession?

Posted on: August 4, 2022 at 09:47:02 CT

https://mises.org/wire/what-happens-national-debt-after-secession

08/03/2022
Ryan McMaken


The topic of secession has become increasing more common in recent years as various regions and minority populations (e.g., California and Texas) has openly suggested breaking away from the United States. The idea is forwarded with varying levels of seriousness, but the fact that talk of secession is increasingly done openly and repeatedly suggests increasing strength for what the political scientists call "centrifugal" forces. That is, cultural and political trends increasingly point toward growing separation and away from increased union.

But even those willing to entertain the idea of national separation will bring up many practical questions about how such a separation would actually take place. One of the most common questions among these people is: what happens to the government's debts in case of secession?

Fortunately, there are some historical examples that help shed some light on what does happen to debts following national break-ups. In most cases, what happens to the debt comes down to negotiations among successor states. The ideal model in these cases is probably the Czech-Slovak separation in 1992. But other examples exist as well, as in the post-Soviet states and in Latin America.

In many of these cases, what happens to the debts depends not only on negotiations between the successor states, but also on negotiations with the third-party states who see themselves as representing a large number of creditors hoping to get their money back. That is, third-party regimes often intervene in secession disputes to pursue arrangements that will increase the odds of repayments of at least a sizable portion of the debt in question.

But sometimes negotiations don't go very far, and successor states—and their supporters—are sometimes simply willing to pay the economic price of separation without a clear debt plan in place.

In any case, experience shows that in spite of debt-repayment being a concern in these cases, national separations can happen and do happen, often without a need for repudiation of existing debts.

Dividing up the Debt

A decade after gaining de facto independence from Spain, Great Colombia began to split up into three smaller countries: Venezuela, Ecuador, and New Granada. Bondholders primarily pursued the repayment of debts from New Granada, but the New Granada regime refused to take on the full burden of Great Colombia's old debts. As part of an effort to gain diplomatic recognition from Britain, all three countries agreed to an apportionment of debt obligations proportional to the populations of the successor states.1 The debt was not repudiated although it was renegotiated on more than one occasion.

The same "population principle" was again accepted in the aftermath of the breakup of the Central American Federation. Consisting of what is now Guatemala, Honduras, El Salvador, Costa Rica, and Nicaragua, the Federation broke up in 1840. External debt—much of it owed to British creditors—was divided proportionally to population in each new republic in return to British recognition of the new states' sovereignty.2

But the population principle has not always been used, and in some cases external debt is taken over entirely by only one party. This is known as the "zero-option" formula. This was true for Colombia which took on all external debt when Panama seceded in 1903, and it was the case when Pakistan retained external debts in the midst of Bangladesh's secession in 1971.3

Other examples of lopsided debt allocation can be found in numerous cases of generally peaceful secession for purposes of decolonization in Africa. In these cases, former colonies seceded, but were not expected to take on a share of the debt owed by the "mother country."

Post-Soviet Secession

Om December 26, 1991, the Soviet Union legally ceased to exist. In its wake were 15 new independent states, the largest of which were Ukraine and Russia. Naturally, many creditors who had loaned money to the USSR still wanted repayment—from someone. This led to a series of negotiations in which the states of the G-7 essentially imposed a repayment system on the new independent states, based on the so-called joint-and-several formula. Beatriz Armendariz de Aghion and John Williamson explain how it was supposed to work:

“The joint-and-several formula imposed on the Soviet successor states was ... a novelty in the context of international debt. Indeed, it is an idea drawn from the very different world of domestic loans made jointly to several partners. In domestic loan contracts, lawyers include the joint-and-several provision to increase the assurance that a loan to multiple partners will be serviced on schedule: the inability of any one partner to pay its share will be offset by additional payments by the others; the lender will suffer no loss as long as at least one of the debtors remains solvent and liquid. Because there is increased assurance of repayments, the loan is presumably made on finer terms than the lender would otherwise concede.”4

For a variety of reasons outlined by the authors, the joint-and-several idea was a "blunder" and it failed. None of the new states other than Russia paid any debt service under the scheme. In the end, the new Russian Federation ended up offering the zero option. The Russian regime volunteered to take on all the debts of all the successor states in exchange for control of all external Soviet assets such as gold and foreign exchange, real estate including as embassies, and the USSR's loan portfolio. Ukraine, however, argued in favor of taking on a share of the debt itself "in order to demonstrate its sovereignty in the area of international finance." The Russian state finally paid off its Soviet debt in 2017.

The Czech-Slovak Split

Perhaps the "ideal" case of a national split is the dissolution of Czechoslovakia in 1992, which was a case of a "highly integrated" federal state peacefully negotiating a separation into two new sovereign states.5 Although negotiations were often tense, both sides did eventually agree to a plan of dividing assets and debts "generally based on relative population and location." That is debts were allocated based largely on a 2:1 ratio with Czechs being the more populous group. However, many aspects of the negotiations were problematic. Both Czech and Slovak activists contended they were being exploited by the other side. The Slovaks, who were outnumbered by the wealthier Czechs often felt the Czechs received an unfair advantage from the fact the assets of the outgoing federation tended to be concentrated in Czech areas. Ultimately, however, negotiations were concluded peacefully.

Politics Often Trump Economics in Negotiations

The downside of national separation has long been the usual problem of political and economic uncertainty: it tends to drive up lending costs and drive down investment due to investor reluctance to put money in jurisdictions with an uncertain political future.6 Empirical studies in secession movements suggest that seceding areas often face a short-term flight of capital as investors hold back to see how things turn out.7 Claims by unionist activists that separation would be disastrous for local finances were employed, for example, in arguments against Quebecois secession in Canada and against Brexit in the UK. Indeed, some research shows that investment fell in Quebec even as secession was merely contemplated—out of fear the region would lose direct access to the larger Canadian economy.

Separation can bring a "secession dividend" in some cases, however. Estonia and Lithuania have clearly benefitted economically from their separation from the Soviet Union. Their economies consistently outpace that of Russia. The United States—itself a product of (a very disorderly case of) secession—has often enjoyed an economy that has outpaced the United Kingdom in terms of economic growth and development. Both Czechia's and Slovakia's economies recovered from their initial post-separation recessions within five years.

Any financial costs of separation must also be viewed in light of what internal political instability, injustice, or violence that might occur if political union continues. Yet, it must be admitted that separations and national dissolution do come with financial costs, especially in the short term.

Not all costs and benefits of changes to regimes and political institutions can be counted in monetary terms, however. Separatists often know that separation comes with costs, but proceed anyway to pursue the psychic benefits of self-determination and the possibility of future improved economic improvement beyond the near term. This is clearly often true in cases of national liberation as occurred in the post-Soviet Baltics and throughout the decolonization processes in the Americas and in Africa. Sometimes the gamble has paid off financially. Sometimes not so much.

Even in the Czech-Slovak split, separatists appeared prepared to accept that the separation might bring significant economic costs. As Robert Young notes in his study of the split, as time went on, the idea of national separation became more and more of a fait accompli in the minds of citizens—regardless of possible economic consequences. What began as a tentative move toward separation thus took on a life of its own and after a time "the choice was no longer between splitting up and staying together but between the orderly and disorderly dissolution of the country."8 In other words, once Czech and Slovak nationalists—a growing portion of the population at the time—made up their minds that separation would happen, the details of dividing up debts and assets in an orderly way became simply a best-case scenario rather than a precondition for separation. As Young put it "On matters where agreement was impossible....[the Czech government was] prepared to accept impasse and to deal themselves with the repercussions."9

The lesson here is that fears over the financial cost of not having every aspect of debt repayment squared away is not necessarily an impediment to national separation. Other political considerations may simply relegate that concern to the back seat. Economists and financiers often like to think they have the most convincing and compelling arguments, but this is often not the case. In many cases, however, post-secession successor states are indeed willing to negotiate terms for debt repayment. This is often done in hopes of speeding international recognition for new regimes, and in hope of establishing the new states as reliable places for new investment. National divorce does happen, and debts are not necessarily repudiated as a result.



1. Beatriz Armendariz de Aghion and John Williamson, "The G-7's Joint-and-Several Blunder," Essays in International Finance, No. 189, April 1993, Princeton University Press. p. 2.
2. Ibid., p. 4.
3. Ibid., p. 2.
4. Ibid., p. 11.
5. Robert Young, The Breakup of Czechoslovakia (Kingston, ON: Queen's University, 1994) p. v.
6. Dane Rowlands, "International Aspects of the Division of Debt Under Secession: The Case of Quebec and Canada," Canadian Public Policy, Vol. XXIII, No. 1 1997.
7. Tim Sablik, "The Secession Question," Econ Focus, First Quarter, 2015, p. 16. https://www.richmondfed.org/-/media/richmondfedorg/publications/research/econ_focus/2015/q1/pdf/cover_story.pdf
8. Young, The Breakup of Czechoslovakia, p. 56.
9. Ibid., p. 64.