What’s it: Sovereign debt is debt issued or guaranteed by the government of a country. In other words, these are 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 debt securities’ risk level 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 should the government go into debt?
Before answering them, I will briefly review the government budget.
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.
Basically, the government budget deficit is primarily aimed at boosting economic growth. Whenever it needs money to finance its growth initiatives, the state can only do it in two modes: raising taxes or going 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
To fund domestic development initiatives, the government issues bonds which are then purchased by domestic investors. There are different types of investors who buy government bonds. They include pension funds, insurance companies, and banks.
Because the investors come from 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 is part of the debt of a country where 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 of the inability to collect taxes. Usually, it occurs during periods of weak economic growth, such as recessions, in which business profits and household income fall.
Government 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 in the world.
Moreover, with 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 it sends ripples worldwide.
The pros and cons 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.
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. There is a possibility of excess supply, and 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 have an effect on 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. This 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. They are flexible in withdrawing their investment to pursue short-term gains or to secure their investment.
The outflow of foreign capital creates pressure on the exchange rate. Pressure on the exchange rate is more significant if, at the same time, the country runs a trade deficit.
Sovereign debt crisis
Not all economies can manage large debts. Some countries have unstable economic conditions, so debt can make things worse.
Countries with high inflation or volatile exchange rates usually have to issue debt securities with high coupons. Its aim is to attract investors who are willing to take risks. This, of course, is a burden on the government budget.
When borrowing too much and cannot pay off the principal and pay the debt’s interest, the country experiences what is known as default. Because states cannot file bankruptcy when they default, they must bid exchange offers to the debt securities holders.
Exchange negotiations are often deadlocked and protracted. If this condition occurs, the government will generally take steps to devaluate the national currency to reduce its debt burden.
Devaluation reduces the purchasing power of the country’s currency. Devaluation can indeed drive exports more widely, which can help increase GDP. But, currency devaluation also means that domestic money is of less value when exchanged for goods and services.
As a result, the public could not buy as much as before. And domestic and international confidence in the economy fell.