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 19th century Council for Ottoman Debt Administration for the Ottoman Empire. Government Bonds are issued in local currency.
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 Russia 1998, Argentina 2001, Mexico 1994, Uruguay 2003 and North Korea 1987. Sovereign debts are in foreign currency. Changes in global economic conditions affect the borrower’s trade with developed countries resulting in currency devaluation increasing debt servicing burdens. It could reach a point when a government fails to service sovereign debt obligations. At that point, international creditors, banks, stability facilities and stabilization 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 European Stabilization Mechanism (ESM) says, 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 Greek economy was doing very well. Cheap loans flowed in as consumers had greater buying power thanks to their currency Euro. Government was comfortable to keep increasing its deficit budget more than the 3% limit on GDP. With mounting debts Greek 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 who had over borrowed.
The governments of Greece, Italy, Ireland, Spain, Portugal and Belgium were facing the effects of “deficit Spending” after things went wrong. Countries who spend more than they earn engage in Deficit Spending. Financing for their burgeoning deficits are managed by 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. Large infrastructure projects could carry a revenue timeline of over 25 years or more. Sovereign Debts used to finance such projects may never generate adequate cash flow or create a tenor mismatch between the project lifecycle and the loan maturity.
For long term foreign currency loans, the most obvious risk is currency fluctuation, followed by political turmoil (for LDCs) and risks of economic downturn in 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 Greek shipping industry. As revenues dropped Greek bonds downgraded from AA to “junk” status. Interest rates were increased as lenders demanded more return on investment from high risk portfolio. Greece had arrived at a default stage, ie 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 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 of importance here, Greek currency is not under sovereign control, and, Greece surrendered to strict conditions, determined by a non-sovereign monetary institution.
19th century Ottoman Sultans were slowly loosing territories on the one hand, and sea based cargoes substituted land based cargoes on the other hand. 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 Ottomans to inject fresh funds in the empire. But economic conditions did not improve much though, 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 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.
Take Bangladesh as a case in LDC, deficit of about 4% of GDP (on the high side) is not too bad, whereas external debt to GDP has declined from 28% in 2007 to 23% in 2009. Foreign exchange through exports and remittances from expat workers fuel industrial engine, which should keep growing in the near term. Bangladesh and other LDCs may wish to avoid an over enthusiastic zealousness attempting mega projects to be financed by sovereign debt. Unless they have absolute conviction that nothing could go wrong in the economy, otherwise, it could be another tragedy.