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 EPW dated
December 12-18, 2008.
