Sovereign debt from a socio-political perspective

M Arif Iqbal Khan History is indeed little more than the register of the crimes, follies, and misfortunes of mankind. - Edward Gibbon With every financial crisis comes a lesson. Financial crises are followed up by sovereign risk crisis and eventually a currency crisis. There are compelling comparisons between China's package for Greece and the 19th century Council for Ottoman Debt Administration for the Ottoman Empire. Government bonds are issued in local currency. The first ever government bond was issued in the UK in 1693 to finance a war against France. Government bonds are thought to be credit risk-free because a government would never default on its own currency. In hard times, governments can print more money or raise taxes to meet payments. Very rarely governments default on local currency loans, exceptions exist like those of Russia in 1998, Argentina in 2001, Mexico in 1994, Uruguay in 2003 and North Korea in 1987. Sovereign debts are in foreign currency. Changes in global economic conditions affect the borrower's trade with the developed countries, resulting in currency devaluation, increasing debt servicing burden. It could reach a point when a government fails to service sovereign debt obligations. At that point, international creditors, banks, stability facilities and stabilisation mechanisms intervene to rescue the defaulting state. The rescue package is intended to save a country's economy (and lenders) but not without some harsh conditions. Article 136, paragraph 3 of the European Stabilisation Mechanism (ESM) says that the member states whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality. Sovereign debts are risky investments for lenders and equally fearsome for borrowing governments. There must exist some compelling reasons for taking on foreign currency loans. Take Greece, for example. In early 2000's, the Greek economy was doing very well. Cheap loans flowed in as consumers had greater buying power, thanks to their currency, the euro. The government was comfortable to keep increasing its budget deficit to more than the 3.0 per cent of the gross domestic product (GDP) limit. With mounting debts, Greece needed only one of the few crisis triggers to make a snowball effect on its economy and beyond. The financial crisis of 2008 let loose a wave of crises in countries which had over borrowed. The governments of Greece, Italy, Ireland, Spain, Portugal and Belgium were facing the affects of "deficit spending" after things went wrong. Countries which spend more than they earn engage in deficit spending. Financing for their burgeoning deficits is arranged through debts. Investing in social projects may never generate the kind of revenue needed to pay off its associated liabilities, however, necessary that project may seem. For instance, old-home care, orphanages, school for autistic children etc. There may be infrastructure projects which could carry a revenue cycle of 25 years or more. Sovereign debts may be used to finance such projects which may never generate adequate cash flow or may take longer than the loan tenor. A tenor mismatch could be a very practical reality. For long-term foreign currency loans, the most obvious risk is currency fluctuation, followed by political turmoil (for the least developed countries or LDCs) and risks of economic downturn in the developed countries (in the case of export-oriented economies). Burgeoning deficits also means ballooning debts to finance those deficits. Any shift in the carefully crafted financing plan can lead to disaster. Drop in global trading in 2009 meant a reduced demand for the Greek shipping industry. As revenues dropped, Greek bonds downgraded from AA to "junk" status. Interest rates were raised as lenders demanded more return on investment from a high-risk portfolio. Greece had arrived at a default stage, i.e., sovereign debt default. Greece had no choice but to accept a bailout package when a default on sovereign debt became imminent. Had the debt been in local, instead of foreign, currency, a default could have been averted. Greece borrowed in euros -- its local currency, yet it failed to service its debt. Greece ceded control to print its own currency as a condition for its accession to the eurozone. As a result, euro-denominated debt was sovereign debt. Two things are of importance here. The Greek currency is not under sovereign control, and, Greece surrendered to strict conditions, determined by a non-sovereign monetary institution. The 19th century Ottoman Sultans were slowly loosing territories on the one hand, and sea-based cargoes substituted land-based cargoes, on the other hand. The Ottoman government was receiving less in tax revenues from citizens as well as lower excise revenue from commerce, making it hard-pressed for funding its growing expenses. Local currency loans were not viable as economic conditions deteriorated, leaving only one option. Sovereign debt was used by the Ottomans to inject fresh funds in the empire. But economic conditions did not improve much and default on foreign currency loans became imminent. As a result of lobbying by international bondholders, the Council for Ottoman Debt Administration was set up in 1881. The council was made up mostly of creditors to the declining empire and they worked directly with Ottoman tax authorities and got funds directly from the government's tax revenue coffers. They realised that the revenues assigned in the original collateral agreement were not generating the necessary capital, so they were able to negotiate for even more of the country's revenues. The Chinese government has started unilateral negotiations with Greece, offering to accept concessions, such as the operation of a particular port, in lieu of interest payments, or in exchange for a liquidity infusion with which to service other bondholders. Coffman, from Morningstar, argues that such deals could become increasingly de rigeur as there are signs that sovereign immunity is breaking down. She cited the example of the vulture hedge fund, Elliot Associates which in the nineties bought convertible loans from Peru, then refused to convert them to Brady Bonds, and sued the government. When Peru quickly settled the dispute, Elliot Associates received six times the amount it would have got through the proposed Brady Bond settlement. Our deficit of about 4.0 per cent of GDP (on the high side) is not too bad, whereas our external debt to GDP has declined from 28 per cent in 2007 to 23 per cent in 2009. Foreign exchange through export receipts and remittance earnings from expatriate workers fuel our industrial engine, which should keep growing in the near term. We may wish to avoid an over-enthusiastic zealousness for attempting mega projects to be financed by sovereign debt, unless we have absolute conviction that nothing would go wrong with our economy. Otherwise, it could be another tragedy. The writer can be reached at email: arifatdhaka@yahoo.com