<b>A V Rajwade:</b> Not on an equal footing

While searching for papers by Viral Acharya after his appointment as deputy governor of the Reserve Bank of India, I came across one titled “Sovereign Debt, Government Myopia, and the Financial Sector” (October 2011), a subject of topical interest to us. (The paper is co-authored by Raghuram Rajan.) My objective was to understand the authors’ views on the issue. Frankly, I was disappointed with the content and logic of the paper; also, I could not understand the conclusion. 

For a start, the paper discusses issues relating to sovereign debt defaults irrespective of the currency of the debt. Surely, sovereign debt in the national currency, in a supranational currency like the euro for euro zone members, and in foreign currency have different implications? This is also reflected in the fact that in the last 50 years the only case I recall of a sovereign defaulting on national currency debt is Russia in 1998, then ruled by an erratic president, with several US economists advising him. The reason why default in sovereign debt in national currencies is rare is simple: Liabilities can be inflated away and honoured by printing notes. Sovereign debt of members of the euro zone, denominated in the euro, is a special case: The currency is domestic, but the central bank is supranational and national governments do not have the option of printing notes. Sovereign debt in foreign currency stands on a different footing altogether because it can be serviced only by earning foreign exchange through exports or otherwise. In fact, most sovereign debt defaults over the last four decades — from Latin America in the 1980s to Mexico, East Asian countries, Brazil, etc in the 1990s, to Argentina in 2001 — have occurred in respect of debt in foreign currency. The paper does not seem to make any distinction between the three situations, treating them all on the same footing, as the references to quasi-public debt in the US and the debt crisis in Greece show.

This apart, the authors have little trust that governments can function responsibly: “Most governments care only about the short run, with horizons limited by elections or other forms of political mortality.” What is less clear to them is “why a country… with its sovereign debt largely financed by external lenders… would be willing to service its debt”. Again, “so long as cash inflows from new borrowing exceed old debt service, they (that is, governments) are willing to continue servicing the debt… Our assumption of government myopia explains why countries do not default even when default costs are small”. In other words, default is the norm for most governments! I could also not understand the logic that governments “need to repress (that is, tax) the private sector in order to channel more savings into government debt”. Surely, higher taxation, within limits, should reduce the debt needs?

I am equally puzzled by the argument that if a country honours the debt owing to the domestic financial sector, but defaults with respect to foreigners “it would be a simple matter once the default is declared for the foreigners to sell their bonds to the domestic investors, who would then collect on them”. Will the argument work if the debt was denominated in foreign exchange or a supranational currency? Where would the domestic financial sector get the resources to buy defaulted bonds from foreigners? Sovereign national currency debt is considered “riskless”. That is why Basel III prescribes the minimum amount domestic banks need to invest in sovereign debt (in parallel with the statutory liquidity ratio in India). I could go on. 

After developing a complex mathematical model, but not presenting any empirical evidence or case studies, the paper concludes that “the costs of defaulting on domestically held bonds… ensures the sustainability of foreign borrowing”. The logic escapes at least this student of finance! I, however, agree with the last sentence in the paper: “There is ample scope for future research.”

The rupee’s exchange rate

After writing the last article about the rupee’s exchange rate, I was reminded how, in the 1970s, the discovery of North Sea oil and high oil prices led to Britain catching the Dutch disease, and the overvalued pound devastated British manufacturing. Are remittances and portfolio inflows our form of the Dutch disease? We, perhaps, need to learn from the late 1990s’ experience of East Asia before circumstances force rethinking of the exchange rate policy of the last eight years.

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com