The declaration by the government-owned
conglomerate Dubai World that it proposes to unilaterally suspend payments
due on its large debt has triggered a new fear in international financial
circles: that of sovereign default. Strictly speaking, the sums owed by
Dubai World were not sovereign debts, but debts incurred by the company.
But because of the nature of the company's ownership, these debts were
seen as (implicitly) guaranteed by the Dubai government. Since Dubai is
part of the United Arab Emirates, these debts were also seen as being
implicitly guaranteed by the leading nation in the group, the oil-rich
Abu Dhabi.
Given these features, the message sent out by the Dubai World declaration
that it plans to suspend and reschedule its debt service obligations was
that in today's world nothing is secure. Other governments too can choose
to default in order to reschedule excessive debt involving cumbersome
payments requirements, buying time today and leaving it to future parties
in power to deal with the consequences. This possibility flagged in by
Dubai together with the changed distribution of sovereign debt globally
has created a peculiar situation: it is not governments of poor developing
countries with limited resources and limited possibilities of transformation
through trade of local into foreign currencies that are now the principal
source of danger, but more developed countries like Greece, Italy, the
US and the United Kingdom.
Governments have always taken on debt: to finance wars, investments and
day-to-day expenditures. Besides borrowing themselves they have also implicitly
or explicitly guaranteed private debt, to facilitate borrowing by non-government
entities. Put these together, and some of them had at different points
in time borrowed "excessively", in the sense that they had accumulated
debt service commitments that were too heavy a burden given their willingness
or ability to mobilise domestic resources to defray such expenditures.
Governments of poorer countries were also victims of the so-called "original
sin" or the inability to borrow abroad (or even at home) in the domestic
currency. This meant that they needed to transform domestic resources
into adequate amounts of foreign currency to meet debt service obligations
denominated in terms of a foreign currency.
Inevitably, therefore, there were two contradictory aspects to sovereign
debt, or debt owed by a national government. The first is that such debt
was considered to be much safer than other forms of debt since it had
the backing of a national government that could (normally) commandeer
the resources needed to meet payments commitments. The other is that such
debt is not all too safe, since unlike in the cases of individuals and
firms, creditors most often cannot force governments to repay debt by
taking them to the courts and having their assets liquidated. Rather,
sovereign debts are potential candidates for compulsory rescheduling in
terms of payment periods, interest rates and valuation or even candidates
for full repudiation.
Repudiation or even compulsory rescheduling is not without costs. It affects
the reputation of the country and government concerned, triggers a sharp
reduction in the rating of its foreign debt and damages the ability of
the country to access further debt. It could lead to the imposition of
trade sanctions against the country by governments of countries from which
its principal creditors originate. And these and other reputational effects
can have political costs for the governments and parties that opt for
such repudiation. It is the existence of such costs that are seen as ensuring
that creditors do lend to governments.
The reality, of course, is that defaults have indeed occurred. In the
past, these have been defaults by developing countries. According to one
analysis (Borensztein & Panizza, 2008) relating to the period 1824-2004:
"Latin America is the region with the highest number of default episodes
at 126, Africa, with 63 episodes, is a distant second. The Latin American
"lead" is, however, largely determined by the fact that Latin
American countries gained independence and access to international financial
markets early in the 19th century, while most African countries continued
to be European colonies for another 100 or 150 years. Among the developing
regions, Asia shows the lowest number of defaults."
Most often defaults in developing countries occur when they have been
the targets of a lending boom. One such boom preceded the debt crisis
in Latin America in the early 1980s. Net resource flows from private creditors
rose sharply in the 1970s, driven from the supply side by the huge inflows
of deposits into the international banking system after the oil shocks
of the 1970s. According to Jonathan Eaton and Raquel Fernandez (1995),
for debtors classified by the World Bank as "severely indebted countries",
such flows peaked at nearly 2 per cent of their GNP in 1976. After the
Mexican debt crisis of 1982, the direction of these flows was reversed,
peaking at over 2 per cent in 1986. Sovereign debt for the group amounted
to 30 per cent of GDP in 1986, partly because the rescheduling process
involved provision of additional loans to prevent default.
The implication of that experience is that in the case of developing countries,
the tendency to default is the result of them having been given and having
accepted external debt that becomes difficult to pay either because they
are subject to some shock or because the magnitude is just too large.
Often a lot of this debt is not even sovereign debt but debt to the domestic
private sector, provided in the belief that there is an implicit sovereign
guarantee. Yet, repudiation is not necessarily an answer to the problem,
since it could lead to reduced access to foreign exchange that is crucial
to sustain domestic investment and even consumption. Developing country
governments, therefore, accept onerous rescheduling terms (in recent years
under IMF tutelage), which saves the creditor from having to write down
those loans while condemning the debtor country to low growth and increased
deprivation.
Having been the victims of such experiences over the last two decades
of the last century, governments in many (though not all) developing countries
have been cautious about taking on too much debt. This was a problem for
finance since over the last decade the international financial system
has once again been awash with liquidity. This has resulted in two tendencies:
first, increased lending to the private sector in developing and developed
countries; and, second, increased lending to developed country governments.
The latter is the source of fear in the post-Dubai World period. According
to The Economist (3 December 2009): "In 2007 average government debt
in the G20's big rich economies, at just under 80% of GDP, was double
that of big emerging economies. By 2014 the ratio, at 120% of GDP, could
be more than three times higher. That alone will challenge old rules of
thumb about the relative riskiness of emerging-market debt. But it will
not be the only change. The scale of contingent liabilities, such as government
guarantees on bank debt, differs hugely between countries, with a far
bigger increase in the rich economies at the heart of the crisis."
The problem has been exacerbated by the effort made by a number of countries
to save their banks by buying out their losses and stimulating the economy
with additional spending. This has not just left the debt overhang problem
untouched, it has aggravated it. Needless to say, the debt is now substantially
government or sovereign debt. But increase in such debt is undermining
the confidence that such debt is risk-free, especially when fiscal deficits,
exceed 10 per cent or more of GDP as they do in Ireland, Greece and Spain.
One economy in the eurozone which is the focus of attention is Greece.
With a budget deficit that is expected to touch at least 12.7 per cent
of GDP, Greece is seen as a country on track to record a public debt to
GDP ratio of 135 per cent. A substantial part of the country debt is owed
to foreign creditors, with two-thirds of public debt held by foreigners
and gross external debt, private and public, estimated at 149.2 per cent
of GDP last year. According to reports, Deutsche Bank has estimated that
Greece would seek to raise some €31 billion in new borrowing and roll
over €16 billion of past debt in the coming year. This suggests that the
country is an ideal candidate for sovereign default. Greece is not the
only potential defaulter. Italy's debt to GDP ratio is forecast to rise
to 127 per cent next year.
Until recently these figures, which point to the potential for default,
were ignored, because stronger economies in the eurozone (like Germany)
were expected to bail out partner countries in the event of a crisis.
But that is unlikely to happen because of the moral hazard involved. If
countries have violated the spirit and letter of the eurozone treaty to
get themselves into this difficult situation, rescuing them would only
encourage them and others to continue with such practices. In the event,
uncertainty builds and investors are paying much money to insure themselves
against sovereign defaults. According to the Financial Times, "the
volume of activity in sovereign credit default swaps--which measure the
cost to insure against bond defaults--linked to the US, UK and Japan have
doubled in the past year due to concerns about their public finances."
This is indeed a whole new context in which problems that were considered
typical of the so-called emerging markets now plague the metropolitan
centres of capitalism. In response, capital is fleeing to safety in emerging
markets, leading to stock and property market booms and an appreciation
of their currencies--all of which increase fragility in those markets
as well.
Borensztein, E., & U. Panizza (2008) The Costs of Sovereign Default,
International Monetary Fund, Research Department, Washington, D.C.: International
Monetary Fund.
Eaton, J., & R. Fernandez (1995) Sovereign Debt, Cambridge, MA: National
Bureau of Economic Research.
* This article first appeared as the H.T. Parekh Finance
column in the Economic and Political Weekly dated December 12-18, 2008.