The recent resurgence of the euro zone sovereign debt crisis in Cyprus, and the proposed "bail-in" of bondholders, has once again raised some fundamental questions regarding sovereign debt, long considered the risk-free benchmark over which all other debt is priced at a spread.
Till the Latin American debt crisis of the eighties, the widely held view, famously articulated by Walter Wriston, head of Citibank, was that sovereigns could not go bankrupt. They could, and did, willfully default on their debt, but nominal default could be avoided by central banks printing money. Several governments, including advanced countries, have inflated their way out of high levels of debt right through history, and may well do so again in the wake-up of the recent build up of public debt to unsustainable levels.
Widespread public debt defaults during the Latin American debt crisis put paid to this belief. These defaults were hardly willful. Latin American governments did not have the capacity to repay debt that was not denominated in their own currencies. Governments, indeed whole countries, could and did go bankrupt insofar as external debt was concerned because their central banks could not print the reserve currencies in which this debt is denominated.
The Latin American debt crisis, however, merely qualified the general belief regarding the "non-bankruptibility" of governments by excluding the external debt component from conventional wisdom. This gave rise to a whole new industry focusing on external debt management.
This belief has now been further eroded in the wake of a full-blown sovereign debt crisis in the euro zone. Peripheral countries are bankrupt not because of their inability to service or repay foreign debt, but on account of debt denominated in their own currency, the euro. This raises some interesting new issues regarding the sustainability of domestic public debt.
In a federation, where both the Centre and states have independent or separate fiscal powers, these issues are better appreciated through the lens of the famous Mundell-Fleming "impossible trinity". According to this trilemma, it is possible to have only two of the following three: a fixed exchange rate, monetary independence and free capital flows.
A country may adopt any constellation of the impossible trinity. The US, the UK, euro zone and Japan, the reserve currency areas, have monetary independence, free capital flows and a floating exchange rate. India's "managed float" closely resembles these countries. China, on the other hand, has chosen a fixed exchange rate, monetary policy independence and capital controls.
At the sub-national level, however, be it a federation or monetary union, the equation is always the same no matter what constellation is adopted at the federal level: a fixed exchange rate, capital mobility within the federation/monetary union, and monetary dependence.
Monetary dependence not only means that sub-national entities cannot use monetary policy for macro-economic stabilisation (which they, of course, cannot), but also that their debt does not have a central bank monetary backstop. Their fiscal policy can consequently be hostage to market forces, as in the euro zone presently, where peripheral sovereign borrowing spreads have risen sharply. In sharp contrast, sovereign spreads are at historic lows in other reserve currency areas, including in the economically stronger euro zone countries and where debt/gross domestic product ratios are higher, on account of the general flight to safety in financial markets and generous quantitative easing by central banks.
Federations have found a way out of the trilemma by substituting federal fiscal backstops for central bank backstops, thus insulating sub-nationals from market revolt. The moral hazard inherent in such fiscal backstops is addressed through the imposition of hard budget constraints on sub-national entities.
Thus, American states are constitutionally barred from running Budget deficits. While Indian states can run fiscal deficits, Article 293 of the Indian Constitution severely restricts the borrowing powers of sub-national entities by requiring prior permission of the federal authority. In China, much of the sovereign borrowing is done by sub-national authorities and State controlled banks. The current market view, however, is that these are backstopped by the federal government. Should the federal government signal that they are not, a euro zone type debt crisis could erupt in future.
This federal fiscal backstop and transfer mechanism is what enables sub-national governments to borrow at rates similar to those of the federal government, with the market mostly overlooking differences in sub-national balance sheets and productivity. Thus, debt stressed Indian and American states, such as Kerala and California, are able to borrow at more or less the same rates as the federal government and other states with better balance sheets.
This is exactly what happened in the euro zone following the monetary union. The market treated the euro zone like a fiscal federation, despite the fact that there was only a fiscal compact (the Maastricht Treaty) and not a hard budget constraint, and no fiscal or monetary mechanism for bailouts. As a result, peripheral countries with weak finances and banking systems and lower productivity - the "PIIGS" - were able to borrow at rates similar to countries with far stronger economies and public finances through capital inflows from other countries within the euro zone that ran current account surpluses.
The global financial crisis laid bare this fatal flaw in the design of the euro zone. The market discovered that there was neither a monetary nor fiscal backstop for the constituent countries. The ad hoc fiscal stops put in place, like the European Stability Mechanism, were too small to bail out the larger euro zone countries like Spain and Italy that were in trouble with bond markets. Peripheral euro zone countries with large fiscal and current account deficits (that made them dependent on external capital flows), consequently became hostage to market forces, with borrowing spreads diverging sharply as capital fled to safer havens within the euro zone.
The outright monetary transactions announced by the European Central Bank calmed markets by holding out the hope that euro zone sovereign debt now had a conditional central bank monetary backstop, leading to a sharp fall in bond yields. However, this belief could well be belied in future if the conditions are not met. After all, the proposed "bail-in" of Cypriot bank debt is effectively a nominal default of sovereign debt as investors are expected to absorb the sharp fall in the face value of Greek government bonds in which their money was invested. This, however, has not affected market sentiment within the euro zone because these investors are mostly "outsiders" (Russians). If the Cyprus model becomes the template for resolving future sovereign debt troubles in the euro zone, which it well might be, bond vigilantes can revisit their recent risk re-profiling of euro zone sovereign debt.
The bottom line is that external debt as well as sovereign domestic debt in poorly designed monetary unions is not free from the risk of nominal default. However, in federations and unitary states public debt denominated in the domestic currency will always remain the risk-free benchmark.
The writer is a civil servant. These views are personal
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
