As a result of the increased liquidity, governments increasingly have amassed more public debt, which if continued, will become unsustainable in the long term. The threat of sovereign default, or a government’s inability to repay its debt, is at its highest in years, according to a recently published World Economic Forum (WEF) report.
Sovereign default could result in economic disaster as funding sources from global markets dry up. All in all, unemployment would rise significantly, as infrastructure projects would come to a grinding halt, and social and political unrest could ensue.
Governments, through their central banks, have been on a borrowing binge. They find themselves on the verge of becoming pariahs to lending institutions, public or private, for trying to revive their failing economies and handing lifelines to banks and companies deemed “too big to fail.”
The WEF report also suggests that nations, despite escalating debt, are hiding their heads in the sand, ignoring a looming financial crisis, and using “Band-Aid” fixes instead of tightening the belt. The International Monetary Fund (IMF) warns that governments disentangling themselves from financial support systems because of a political backlash from taxpayers could push themselves into the next financial crisis.
Besides the WEF, the IMF warns in one of its publications that “the public debt to GDP ratio cannot increase indefinitely,” according to IMF Fiscal Affairs Department Director Carlo Cottarelli in a statement. “The goal should be to reduce debt levels to where they were before the crisis.”
Financial Stability at Risk
The first indication of a country’s looming debt crisis most often comes from credit agencies that lower its credit rating because of economic or political turmoil. For sovereigns, the credit raters are Standard & Poor’s (S&P), Moody’s Investor Services, and Fitch Ratings.
Moody’s suggests that national governments’ ability to lower debt or finance macro and micro economic projects from internal sources—such as taxation—is uncertain, as they have already squeezed as much as possible out of its residents and companies.
As of date, Moody’s has a negative credit outlook for 10 European countries, including Ireland, Portugal, Greece, and Hungary.
In January, S&P lowered Japan’s outlook from stable to negative, signaling a lowering of its credit rating in the near future. Japan, considered to be the world’s No. 2 economy, was downgraded because of rising deficits and slow growth, due to an aging populace who will soon begin to draw on retirement benefits instead of producing for the country. This action could make it more expensive for Japan to raise funds in the global markets, as the risk associated with lending to Japan would demand a higher price.
Fitch agrees with the WEF and others stating that “the extraordinary sovereign intervention and support for the financial sector, as well as fiscal stimulus packages and the severity of the recession, have weakened high-grade sovereign credit profiles,” making 2010 a tough year for governments throughout the world.
Coming to the Rescue of Country Debt
The Paris Club, the informal group where sovereign debts are negotiated, rescheduled, restructured, or cancelled, developed from a meeting between the Argentine government and its creditors to prevent an Argentine default in 1956.
The IMF is a lifeline for many nations. It provides financial assistance to countries that have run into financial and economic difficulty, so the particular country can purchase basic necessities. Alas, in accepting IMF assistance, the country has to implement reforms that are hoped to bring back financial health.
The Paris Club wrote off Iraq’s debt in 2004, and Nigeria was the first nation to pay off its roughly $30 billion of sovereign debt in full in 2006. In July 2009, the Paris Club cancelled $214 million of Haiti’s debt and in January this year, it called on its other debtors to follow suit. In September 2009, the Club cancelled almost 100 percent of the Central African Republic’s debt and in November 2009, it reduced Comoros’s debt by 80 percent.
“These nations don’t realize that any debt forgiveness or reduction results in an unwillingness by another foreign sovereign to lend funds in the future and for quite some time,” said one unnamed government analyst. “The country is watched closely and only after it has shown good money management and the willingness and ability to pay down debt will lending by foreign nations begin again.”
Sovereign Debt Ratings in a Nutshell
Sovereigns, just as private or public sector companies, are assigned a credit rating by credit agencies.
A sovereign’s rating, just as companies’ ratings, may have an investment grade or junk rating, which tells the investor if the sovereign entity is willing or able to repay its debt. It indicates the probability of a default, taking matters such as the level of debt, non-payment, restructuring, and payment of existing debt under advice.
Having said the above, there is still a distinct difference between a sovereign rating and a country rating. “Sovereign ratings address the credit risks of national governments, but not the specific default risks of other issuers [those without a sovereign standing],” according to a S&P report.
Any country with a high credit rating will find it easier to issue bonds or other vehicles to attract investment capital.
