Contents
What’s it? Sovereign debt is debt issued or guaranteed by a country’s government. In other words, it is debt securities issued by the national government. This is different from municipal debt, where the issuer is the local government.
Like other types of debt securities, the risk level of debt securities is reflected in the interest rate (coupon) offered. The higher the risk, the higher the coupon offered.
Traditionally, government debt has been considered low risk. This is because the government is believed to have various means of ensuring that they do not fail to fulfill their obligations. In extreme cases, the government may force citizens and businesses, using military force, to pay high taxes.
Why governments borrow
A country can exercise three fiscal budget options: surplus, balanced, and deficit. The three differ in whether government revenue exceeds, equals, or is less than government spending.
Under the fiscal deficit, government revenue is less than expenditure. The primary source of government revenue is from taxes. Therefore, in some textbooks, the author may mention that a deficit occurs when tax revenues are lower than government spending. Conceptually, they are the same.
Where does the government cover the deficit?
Due to insufficient income, a possible option is a debt. It’s similar to your budget when you want an item, and your income is not enough, you can apply for a new bank loan.
The government budget deficit is primarily intended to boost economic growth. Whenever the state needs money to finance its growth initiatives, it can only raise taxes or go into debt.
Tax increases are generally unpopular, burdensome to society, and require a lengthy ratification process. So, the government tends to choose to issue debt in the form of issuing government debt securities.
So, in general, the current government debt reflects the budget deficit accumulation over the previous years.
Types of Sovereign Debt
Based on the creditors, the state debt is divided into two categories:
- Domestic debt
- International debt
Domestic debt
To fund domestic development initiatives, the government issues bonds, which are then purchased by domestic investors. Different types of investors buy government bonds, including pension funds, insurance companies, and banks.
Because the investors are domestic, this type of bond is considered risk-free of capital flight. Thus, the effect on the exchange rate is minimal. When in economic turmoil, it is less likely that capital flows out of the bond market if most buyers are domestic investors.
International Debt
International debt is part of a country’s debt when the buyer is an investor abroad. These loans, including interest, usually have to be paid in the currency in which the loan was made, such as US dollars, Euros, and Japanese Yen.
To obtain the currency needed to repay loans, the borrowing country can sell and export goods to the lending country. Or, the government can convert its revenues into foreign currency.
A debt crisis can occur if a country with a weak economy cannot pay off its foreign debt. The state cannot pay the debt because it is unable to collect taxes. Usually, it occurs during periods of weak economic growth, such as recessions, in which business profits and household income fall.
Sovereign debt health indicators
An essential indicator of a country’s economic health and debt level is the debt-to-GDP ratio. A high debt-to-GDP ratio indicates a higher risk of default.
Korea, Hong Kong, and Russia are some countries with a debt-to-GDP ratio of less than 40% in 2019. Meanwhile, countries like Greece and Italy have a debt to GDP ratios of more than 100%. You can access the data sovereign rating indicators from Standard and Poor’s.
However, high ratios may not always be bad. Some countries with more stable economies have a high tolerance for the risk of default. For example, even though the United States has a high debt-to-GDP ratio of 111.95%, it is offset by a strong US economy.
Despite all these things, debt creates obligations that must be paid. Countries must learn from the Greek debt crisis, where debt has become a source of crisis not only in the country but also worldwide.
Moreover, in the current era of globalization, the effects of the crisis can quickly spread. So, the government must handle sovereign debt problems with great care as they send ripples worldwide.
The pros and cons of sovereign debt
Sovereign debt, while a tool for governments, can be a double-edged sword. Let’s explore both the potential benefits and drawbacks of national borrowing:
Advantages of sovereign debt
Some supporters believe that debt is needed to run the economy. There are several advantages of government debt, including:
First, it helps drive economic growth. Countries cover their deficits by borrowing. The government can use debt to fund development projects in the country. Developments such as infrastructure and education contribute to increasing the productive capacity of the economy.
If loan funds are unavailable, development initiatives will certainly not work. And this can hinder a country’s development in the long run.
Second, the government can use debt as a channel for economic policy instruments. Through economic policy, the government tries to avoid the adverse effects of fluctuations in the business cycle.
To do so, the central bank can use debt securities in conducting monetary operations. When it wants to moderate economic growth and inflation, the central bank will sell government debt securities. Conversely, when it wants to encourage economic growth, the central bank will buy government debt securities in the market.
Third, the issuance of debt securities stimulates a growing corporate bond market. Government debt securities are usually the benchmark for corporate debt securities. Thus, the development of the sovereign debt market allows the corporate bond market to develop as well.
Disadvantages of sovereign debt
However, critics argue that government debt has several drawbacks, including:
First, government debt creates a crowding-out effect. If the government borrows too heavily on the domestic market, it reduces the money that the private sector can borrow.
A massive issuance means more supply. If there is excess supply, the market cannot absorb government debt securities. In such a situation, the government may offer high interest rates to lure investors and attract demand.
Higher interest rates can discourage private investment because capital costs are higher. Reductions in private investment can dampen economic growth more than government spending can stimulate.
Second, it can affect currency devaluation. If a country experiences default, the natural tendency is to lower its debt burden. This is often achieved by devaluing local currency. Devaluation means reducing the purchasing power of the domestic currency, which can erode confidence in the domestic economy.
Third, debt is vulnerable to capital flight. The high level of foreign ownership in government debt securities makes the economy vulnerable to speculative action. Investors are flexible in withdrawing their investments to pursue short-term gains or to secure their investments.
The outflow of foreign capital creates pressure on the exchange rate, which is more significant if the country runs a trade deficit at the same time.
Sovereign debt crisis: a cautionary tale
While strategic debt can be a useful tool, excessive borrowing can lead a country down a perilous path – a sovereign debt crisis. Let’s delve into the warning signs and potential consequences using a real-world example:
Several factors can contribute to a sovereign debt crisis. High levels of government debt, coupled with inflation and volatile exchange rates, create a risky environment. This can erode investor confidence and make it increasingly difficult for the government to borrow money.
For instance, in the Greek debt crisis of the late 2000s, a combination of factors converged. Greece had accumulated a high debt-to-GDP ratio, exceeding 100%. Inflation was rising, and the Eurozone experienced significant economic turmoil. This perfect storm eroded investor confidence, making it expensive for Greece to borrow money.
If a country reaches a point where it can no longer meet its debt obligations, it defaults. This signifies an inability to repay the principal or interest on its loans. In such a scenario, the government may attempt to restructure its debt, negotiating with creditors to extend payment terms or reduce the amount owed. Another potential response is currency devaluation, deliberately weakening the national currency to lessen the debt burden.
In the case of Greece, the country narrowly avoided default through a series of international bailouts. However, it was forced to implement harsh austerity measures, including tax hikes and spending cuts. This austerity approach aimed to reduce the debt burden but also triggered a deep recession and social unrest.
A nation in turmoil
A sovereign debt crisis can have severe economic and social repercussions. A weakened currency often leads to higher import costs, pushing up inflation and eroding citizens’ purchasing power. Investor confidence plummets, hindering investment and economic growth. The overall outcome can be a period of economic stagnation, social unrest, and potential contagion as the crisis spills over to other countries.
The Greek debt crisis not only impacted Greece but also sent shockwaves through the Eurozone. Fear of contagion spread to other European countries with high debt levels, leading to a broader economic slowdown.
The Greek debt crisis serves as a cautionary tale, highlighting the potential dangers of excessive sovereign debt and the domino effect it can have on a nation’s economy and beyond.
