By Kelvin Tai - Economics and Management Student @ Harris Manchester College, Oxford
Governments may need a cash infusion sometimes to fund the development of public works or to implement an expansionary fiscal policy. Taxation can be very unpopular with the people, while inflationary concerns cap the amount of seigniorage revenue that a government can create through printing money. As such, some governments issue sovereign debt to borrow from other entities.
Governments primarily borrow through the issuance of bonds. These include treasuries and gilts, among others. Investors buy these bonds, hence handing cash to the government, in return for the promise of higher repayments in the future. Government debt is more feasible when the interest rate is low, so the return on investments by the government is more than sufficient to pay off the investors. Governments may also borrow during the troughs of economic cycles to smooth out consumption over time and reduce volatility.
The difference in sovereign and private debt lies in the fact that sovereign debt is owed by an entity with several levers to pull should it run out of options to repay. Governments that need to repay debts denominated in their own currency can pay it off by printing money. This in effect is a transfer of wealth from lenders to the government since the real value of the debt falls. Former Federal Reserve Chairman Alan Greenspan is quoted as saying: “The United States can pay any debt it has because we can always print money to do that”. Due to the U.S.’s dominant position as a reserve currency, this ability to print money extensively without triggering hyperinflation has caused U.S. Treasuries to be regarded as risk-free. However, recent loose fiscal policy has led to a fall in U.S. dollar reserves held by other central banks globally and further indebtedness could lead to the reserve currency status being threatened.
Some governments may choose to default on debt, and there is little an investor can do to recover the funds. Some parties can seek recourse through legal avenues. For instance, Elliot Management caused Argentinian government bank accounts based in Belgium to be frozen as the hedge fund sought to recover repayment for sovereign debt it had bought at distressed prices.
There exists the potential for a principle-agent problem in government borrowing. A government that is concerned with keeping itself in power might be incentivised to borrow and hence shore up short-term spending to increase its popularity even though repayment might be difficult. A legal theory proposes that “odious debt” (debt that is taken out by leaders for personal enrichment against the interests of the population) does not have to be repaid. This forces lenders to consider what the funds will be used for and lend only for legitimate government business, lest they be refused repayment in the future. In 2015, a committee known as the Truth Commission convened by Greece’s Parliament found that a large part of the country’s debt was odious since the IMF knew that the repayment was unfeasible at the time of debt issuance.
In conclusion, sovereign debt is hardly as boring and riskless as some may assume, for the power asymmetry of governments and the differing political considerations that they have can add variation to the risk profile of debt.