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

One of history's largest repatriations of sovereign and commercial debt occurred in Germany between 1931 and 1939. Our study of the episode finds that German authorities kept private initiatives of debt repatriation under increasingly strict control in order to avoid known detrimental macroeconomic effects, yet allowed the practice on a discretionary basis as a way to reap internal political benefits. The repatriated bonds exhibited a non-negligible and varying spread between their domestic prices and their respective prices on foreign stock markets. We analyze nine years of weekly spreads to argue that the crucial factor for the origination, variation and persistence of the spread was the impact of capital controls on the efficiency of secondary markets. Additionally, we model how internal redistribution motives in the form of elite capture affect socially optimal debt repatriations, merging established results in the literature on debt buybacks with recent research that links the efficiency of secondary markets to sovereign risk. Our analysis offers a comprehensive interpretation of the salient aspects of the historical episode as well as novel insights for several open debates in international macroeconomics.