5.2 Flashcards
what is sovereign debt?
when expenditure exceeds income, difference is made up with borrowing
govt budget deficit -> public/national debt
citizens’ saving deficits -> private/personal debt
which govs borrow?
everyone
top 20 debtors:
- many low income, emerging markets (Sudan, Venezuela, Argentina)
- also high income, market leaders (Japan, Singapore, US)
- Europe-heavy (Greece, Italy, France, Spain, Belgium)
who lends to govs?
since 1970s: private foreign capital > foreign aid and FDI
- multilateral institutions (IMF, WB)
- bilateral governments (China, US, etc.)
- private market (= International Sovereign Bonds (ISB))
private market = “international Sovereign Bonds (ISB)”
- commercial banks issue loans (less popular since 1980s)
- asset managers (pension funds, other private investors) & citizens buy sovereign bonds (seen as save investments, e.g. US treasury)
- central banks (like ECB during covid)
debt is unproblematic when:
interest rate (r): cost of borrowing: percentage of principal loan that is due per period
economic growth (g): percentage change in value of goods and services produced within period
debt “works” when r<g (interest rate-growth differential)
when interest rates increase or growth slows, debt becomes unsustainable
when eco growth is larger than the cost of borrowing
why borrow?
- investment in growth
- consumption smoothing (to manage crises)
- short-term boost in domestic economy
!debt is inter-temporal: future generation responsible for paying it back in taxes
investment in growth:
- especially in poor countries: low domestic savings -> low investment
- debt fills this savings gap
- “works” if truly spent on growth-enhancing projects (not consumption or “white elephants” (prestige projects that don’t actually produce growth)) = bc when you have to pay it back your econ is larger, can bear the cost of repayment
consumption smoothing (to manage crises)
- crisis (e.g. pandemic) with huge, sudden costs: borrow to smooth costs out over the future = also called TAX SMOOTHING
- (essentially Keynesian)
- one crisis this can help with: Climate crisis
short-term boost in domestic economy
- attractive to politicians: purchase goods to reward supporters, increase popularity by borrowing to fund war, use debt for a short-term eco stimulus before an election
- in the long-run: debt problematic if it doesn’t boost eco growth, short run helps win elections
- TIME-INCONSISTENCY PROBLEM for short-sighted elected officials
debt and climate crisis
sovereign debt + climate change are both INTERTEMPORAL PROBLEMS: future generation faces the costs
- gov can borrow $$ to invest in climate change mitigation
- instead of experiencing environmental disaster, next gen will pay higher taxes (will probably be less costly than having to live through the crisis)
debt-for-nature swaps: creditors forgive part of debt in exchange govt expands conservation
blue and green bonds: govt borrow and use funds for climate mitigation and environmental investments
is this the answer to all our climate woes?
probs not: meaningful climate mitigation would likely need to come through grants, massive debt relief for low-income states, or massive low-cost lending
sovereign borrowing is not the same as private borrowing!!!
public debt is not the same as private debt!!
gov can be in constant debt -> why can’t private firms/people
- gov lives forever (+ new govs often respect debt that previous governments had)
- CB can influence r to reduce debt service (e.g. Japan, US, UK)(when you borrow in your own currency, CB can lend trough sovereign bonds (with low interest rate) + can cause inflation by printing money)
- MULTIPLIER EFFECT: govt sending (&other fiscal policy) can influence g (lot of gov spending leads to economic growth)
- gov can force household to repay its debt (via the courts) -> who forces te govt to repay?
risk of borrowing
- if debt servicing becomes too expensive, it can crowd out other spending (the more you spend on financing your debt, the less you can spend on infrastructure, education etc.)
*WB: 3.3 billion people live in countries that spend more on interest payments than on either education or health - high debt may cause inflation, or make it hard to lower inflation (high interest rates problematic if some of your debt is paid at those interest rates + tempting to print money to repay debt)
debt service capacity
= ability of the government to make payments on interest and principal as required by loan terms
- function of foreign reserves: govt needs dollars (or euros or yuan) to repay debt
- creditors don’t accept local currency, want their own currency
(principle = actual amount of the loan, what the gov borrowed)
what happens when export collapses? -> not enough foreign reserves to repay
Russia 2022: US sanctions froze Russian assets, creditors demanded to be paid in dollars, not rubles -> Russian ran out of dollars, defaulted in April
capital flow cycle
- there is an excess of currency in the world seeking a home (supply of money is high)
- banks don’t like to sit on money: want to invest rather than led it erode with inflation -> look for ways to spend it - foreign capital floods a country with a demand for capital (country starts taking debt)
- stimulates economic boom: more borrowing -> more jobs and consumption + capital account surplus
- encourages financial leveraging and risk taking: more money and fewer safe assets + investors have FOMO (-> more lending)
- culminates in a crash as banks realize they’ve made too many bad bets and restrict credit to most borrowers (CREDIT CRUNCH)
- countries start defaulting, lend more to finance debt but take on more debt as a result
e.g.
- 1980s L-A Debt crisis
- 1997 Asian Crisis
- Mexican 1994 crisis
- Russian, Brazilian, Turkish and Argentinian crises (late 90s)
- Germany 1930s
- Great recession of 2008/2009
how does a debt crisis happen? illustration of a circle
- gov borrowers (needs to pay interest and eventually principal)
- debt starts to accumulate -> creditors start to worry if gov maybe won’t pay them back -> credit ratings go down and interest rate go up (bc higher risk)
- credit crunch, borrowing gets more expensive (bc country considered less-credit worthy) -> gov may borrow even more to pay off some creditors in short-term
- govt misses a payment: default -> panic: capital fight (portfolio investment leaves) -> domestic economic crisis
- restructuring debt (often with help institution): debt relief, haircut (every creditor only gets a specific % back), more time to repay
- punishment: creditors don’t trust gov + no access to private credit for a while
- eventually markets will forgive you and the cycle can start again
!at any point the gov can intervene and stop this process
what happens when there’s a debt crisis on the horizon?
Gunboat diplomacy = foreign policy goals achieved by threat of military force
- 1902: Germany, Britain & Italy imposed a naval blockade on Venezuela: pay us back or else
not really accepted/done/effective anymore -> less costly options:
-> gov repays debt (austerity or print money) or defaults
horizon of crisis - solution 1a: print money
govt needs money to repay creditors, so it just prints more!
- Citizens hate it: inflation is painful, especially for poor
- Creditors hate it: their investment is worth less
- Not a popular strategy to cause inflation. However, this could be a side benefit of inflationary periods: debt is worth less
ORIGINAL SIN (Eichengreen, Panizza, & Hausmann): governments can’t borrow domestically or internationally in their own currency
- some gov is not trusted enough to borrow in their own currency -> can’t take on debt in own currency -> can’t repay by printing money
this is often the case
- Creditors worry govt might print more money to “inflate away” their debt, so they only lend in other “safe” currencies
- Govt needs access to dollars, euros, yuan to repay debt
horizon of crisis - solution 1b: austerity to repay debt
Austerity: govt cuts spending and/or increases taxes to raise the money it needs to repay creditors
- Creditors love it. We’ll come back to this and the IMF
- Citizens…sometimes hate it (think Greece 2013 from last lecture). Sometimes they don’t mind, austerity can be popular (e.g. UK tories)
ongoing debate about the effects of austerity:
Leaders may bepunished at the next election, or maybe
voters don’treallycare*Sometimes helps economic growth by reducing wasteful spending, sometimes harms growth by cutting investment21
horizon of crisis - solution 2: default
gov misses a payment to one or more of its creditors
consequences:
- eco crisis: capital flight, unemployment, recession
- damage supporters: right-wing voters may be both investors and citizens
- reputation: credit rating drops, more expensive to borrow in future
- institutions: some countries have rules/norms that punish a leader for fault
country that defaulted the most in history = Argentina
