Sovereign Borrowing

Sovereign Debt, Solvency, and Debt Crises

Unfortunately, history has shown that sovereign debts may also be used by dictators to enrich themselves or to provide benefits to their supporters.

Sovereign debt have a long history and may be traced back to antiquity, but large-scale borrowing seems to have emerged only in the fifteenth century. The market for sovereign bonds grew over time and there were several changes in the nature of the bondholders.

By its very nature, governmental borrowing is somewhat arcane and usually takes place beyond the purview of the typical citizen’s personal interest.

However, at all times, sovereign borrowing affects everyone in society—after all, when a government borrows it hands a piece of the obligation to every taxpayer.

Normally obscure, sovereign debt sometimes suddenly seizes headlines and becomes spectacularly important for everyone in a society under stress.

Figure I: Gross public debt-to- GDP ratios in the United States | Source: The Atlantic, The Long Story of U.S. Debt, From 1790 to 2011, in 1 Little Chart. Opens in new window

Historically, sovereign debt has often been the consequence of wars. Figure 1 depicts its evolution since 1800 in the United States.

Up until the First World War, sovereign debts were held by bondholders and banks. The First World War Opens in new window led to the emergence of large scale loans between sovereigns. The amounts involved were substantial and the question of inter-allied debts plagued international relations during the interwar period. After the Second World War, as a consequence of the Bretton Woods agreement Opens in new window, a notable amount of debt took the forms of intergovernmental loans.

Public debt Opens in new window can reach multiples of GDP without much damage: although its sovereign debt ratio twice exceeded 250% of GDP, the United Kingdom always met its financial commitments, as did the United States, with debt peaking at 121% of GDP in 1946.

Comprehensive research by Carmen Reinhart and Kenneth Rogoff (Reinhart and Rogoff, 2014) has shown, however, that these two cases are more the exception than the rule:

Since 1800, there have been several waves of sovereign default associated with wars and economic crises.

In the second half of the twentieth century advanced countries met their obligations, but emerging and developing countries experienced debt crises that ended in debt restructuring or at least rescheduling.

Overall, the proportion of countries in default each year has often been above one-third (see Figure II).

Figure II: Percentage of countries in default on their external debt, 1800 – 2010 | Source: World Economic Forum Opens in new window

These facts raise three questions:

• First, how did the United States, the United Kingdom, and a few other countries succeed in reducing their debt levels?
• Second, why and how are countries driven into insolvency?
• Third, what are the consequences of it?

The United States and the United Kingdom after World War II essentially relied on a combination of (1), (3), and (4). In a rather high nominal growth context, maintaining low bond rates through central bank policy helped keep the debt burden low.

Answering the second question is more demanding.

It is relatively easy to determine when a household or a private firm is insolvent, but the same does not hold for a government. Unlike households, governments are assumed to have an infinite lifetime, so their debt never requires to be redeemed.

To be more precise, expiring debt will be paid off through new borrowing because it is reasonable to think that future generations will be willing, when their turn comes, to continue investing part of their wealth in government securities.

Is there no limit to the state’s borrowing capacity?

Asking this question amounts to assessing the state’s solvency, that is, the availability of resources allowing it to meet its commitments.

At first sight, the capacity of a state to ensure the service of its debt could appear unlimited since it has the power to raise taxes or, if the central bank is not independent, to monetize the deficit (which is another way of taxing since inflation reduces the real value of money balances and fixed-income securities such as standard bonds).

However, there are political limits to the citizens’ willingness to pay. As illustrated by many historical episodes, from Ancien Régime crises Opens in new window to the Greek crisis of the 2010s Opens in new window, bankruptcy occurs when citizens no longer accept a further reduction of their income and wealth to the profit of the state’s creditors. In the words of former senior IMF official John Boorman:

Determining these political, social, and moral thresholds is a daring exercise. The Greek debt saga of the 2010s illustrated this uncertainty vividly: whether or not Greece was able to repay its debts was a matter of constant controversies within and between international institutions.

The political dimensions of the issue became even more prominent after the leftist coalition led by Aléxis Tsipras won the general election in January 2015, as this change of majority signaled a seriously diminished tolerance for fiscal adjustment on the part of the Greek citizens.

If resources exist but cannot be mobilized immediately (for example, in the case of state-owned companies that cannot be sold immediately due to lack of purchasers), or if they are available but can dry up a short notice (in the case of short-term credit extended by foreign banks), there is a risk of liquidity crisis whereby the government is unable to meet the exact schedule of its obligations.

Finally, public finance is said to be unsustainable if, on the basis of the current economic policy and of available forecasts, the expected development of the public debt leads to a situation of insolvency.

Fiscal policy can therefore be unsustainable without solvency problems arising immediately. Nonetheless, this policy will have to be modified in the future.

Public finance sustainability is especially important in a monetary union where the central bank is independent and does not have the mandate to serve as a lender of last resort for sovereigns. This issue has been a matter of lengthy and controversial discussion in the euro area.

When a company goes bankrupt, a competitor buys it up or it is liquidated, in which case its assets are seized by the creditors. A household may similarly lose its assets (e.g., its house). But there is no collateral for sovereign debt Opens in new window.

If a state defaults on its commitments, neither domestic nor foreign creditors can seize its assets (unless the latter invade the country). An indebted state’s attitude toward its creditors therefore depends on its willingness to pay as well as on its ability to pay. Default Opens in new window can be the outcome of a rational decision not to repay the creditors (in which case it is called strategic default).

This brings us to the third question: What are the benefits and costs of a strategic default?

The benefits result from writing off the debt and the corresponding interest burden, while the costs are mainly reputational: the state may be cut off from financial markets or at least pay a higher risk premium on future borrowings because markets will price the risk of another default.

• In the first case it preserves its reputation, but, before it succeeds in putting its debt ratio on a convincingly declining path, it is likely to be facing high borrowing costs;
• in the second case, its solvency will be improved, but it may suffer lasting reputational damages.

Careful analysis of twentieth-century debt restructuring episodes yields two important lessons.

First, reputational damages are limited: markets tend to forgive debt restructurings. More precisely, they do not punish renegotiation or restructuring per se: after an agreement has been reached with the creditors, governments regain market access, and future bonds spreads are correlated to the size of the restructuring (Cruces and Trebesch, 2013).

Second, significant debt reliefs are positive for growth, especially when accompanied by reductions in the face value of the debt instead of a mere reduction of the present value (Reinhart and Trebesch, 2016).

The upshot is that when a country struggles with unsustainable debt, a debt restructuring may be desirable. The quality of the negotiation process matters, however: markets punish unilateral defaults.

Ultimately, the decision will depend on the level of the primary deficit since a defaulting country will be unable to finance its primary deficit in the short term after the credit event.

It will also depends on the damage created by a default Opens in new window on the domestic financial sector (since domestic banks may hold large amounts of domestic sovereign debts Opens in new window) and on the dissemination of the debt along domestic households.

Since governments suspected of not being able or willing to repay their debt carry a higher interest rate, there is a risk of vicious circle: as detailed in the public debt dynamics literature Opens in new window, the higher the interest rate, the higher the required primary surplus for debt stabilization, hence the lower the willingness of domestic taxpayers to continue the fiscal adjustment.

Figure III Sovereign spreads vis-à-vis Germany (differences in 10-year sovereign interest rates in percentage points).

Such vicious circles were at the core of the European debt crises of 2010 – 2012 (Figure III): interest-rate spreads (or differences) vis-à-vis Germany increased from being negligible to levels that exceeded eight percentage points for Ireland and five for Spain.

None of these countries defaulted, but Ireland and Portugal (as well as Spain for the financing of bank rescue) were forced to apply for support from the IMF and the ESM.

What these developments suggest is that the interplay between market expectation of default and actual borrowing conditions is at the core of sovereign debt crises. We return to the issue in the next post to understand how solvency can be more precisely defined.