Foreign Debt, Capital Controls, and Secondary Markets: Theory and Evidence from Nazi Germany

Journal: Journal of Political Economy

Date: 20240601

Author: Papadia, Andrea; Schioppa, Claudio A.

Abstract:
We investigate how internal distribution motives can affect the implementation of an important macroeconomic policy: capital controls. To do this, we study one of history's largest debt repatriations, which took place under strict capital controls in 1930s Germany, providing a wealth of quantitative and historical evidence. We show that the authorities kept private repatriations under strict control, thus avoiding detrimental macroeconomic effects, while allowing discretionary repatriations in order to reap internal political benefits. We formalize this mechanism in a model in which elite capture can affect optimal debt repatriations and the management of official reserves under capital controls.

Link: Google Scholar

Key Findings

Private Initiative and Elite Capture

Debt repatriations in 1930s Germany began as private initiatives but became a tool for elite favoritism under capital controls, reaching 2% of GDP at their peak in 1933.

Political Economy Mechanisms

The Nazi regime used foreign exchange allocation for repatriations to reward supporters while maintaining strict control over the economy, despite scarce foreign reserves.

Secondary Market Impact

Exchange controls created persistent price spreads between German bonds traded domestically versus abroad, enabling profitable arbitrage opportunities for favored entities.

German Debt and Repatriations Over Time

Total German foreign debt peaked at 97.8% of GDP in 1931
Repatriations reached their maximum of 1.18 billion RM (5.1% of outstanding debt) in 1933
By 1938, debt/GDP ratio had fallen to 14% through defaults and repatriations

Foreign Exchange Reserves and Control

Official reserves declined from 2.89 billion RM in 1928 to 0.08 billion RM by 1938
Secret reserves increased from 0.04 billion RM in 1933 to 0.42 billion RM by 1938
Tighter exchange controls coincided with growing secret reserves

Bond Price Differentials

Premium for repatriation-eligible foreign currency reached 250% by August 1934
Price spreads widened after major policy changes in 1933-34
Spread persistence enabled continued arbitrage profits for regime-favored entities

Contribution and Implications

Demonstrates how capital controls can be exploited for political patronage while maintaining macroeconomic control
Shows that elite capture affects optimal debt repatriations and management of official reserves under capital controls
Highlights importance of secondary markets in sovereign debt dynamics and capital control effectiveness

Data Sources

Debt and GDP data from Table 1: "German GDP, reserves, foreign debt, and debt repatriations"
Foreign exchange reserves data combines official and secret reserves from Table 1
Bond price premium data from Table 2: "Premium for Foreign currency eligible for debt repatriations"