November 2, 2020, 12:30–13:45
Trade sanctions are often presented as a mechanism to enforce sovereign debt contracts. This paper explores how bond markets reacted to the threat and imposition of trade sanctions following the German external debt default of 1934. When the German government announced its intention to default in June 1934, creditor countries adopted different commercial responses. We exploit a unique feature of the interwar sovereign bond market to analyze how bondholders assessed these various responses. Identical Pound Sterling German government bonds (Dawes bonds) were traded continuously on four European markets throughout the 1930s but market segmentation prevented international arbitrage. We show that prices for identical Dawes bonds diverged across European markets following the 1934 default, reflecting bondholders’ expectations of a selective default. The perceived probability of repayment was higher in countries which had granted Germany more favorable commercial conditions and lower in those which had imposed trade sanctions. Our historical case study suggests that the “transfer problem” can largely undermine the effectiveness of trade sanctions in inducing sovereign debt repayment.