Sovereign Debt

Borrowing money

This sounds like the most boring of topics, well if you understand what that means. It’s an old-ish term and the meaning is “Sovereign” as in “a country is a sovereign state” and debt, well that has the same meaning as usual: “money owed”. So this has to do with how independent(sovereign) states borrow money. I would argue that credit default swaps and collateralized debt obligations can be seen as more boring than this topic but it’s not clear cut.

So Sovereign Debt may seem uninteresting because surely countries just borrow money like everyone else? No, no they don’t. Consider what happens if you want to borrow money from a bank.

  1. You’re probably going to have to put up collateral.
  2. The bank is the big player and it has lots of little borrowers.
  3. The bank can foreclose on your loan whenever they want.
  4. The interest rate is variable over time.

Collateral is an asset(a car or a house) that the lender can sell to get back the money you owe them if you don’t pay them. It the first stumbling-block because in a normal bank loan the bank can only take the collateral through the courts. But when the borrower is the state of France, how is a lender supposed to strong-arm the government into paying up? The courts get their authority and funding from the state itself. This is well understood so when sovereign states borrow money they don’t even pretend to put up collateral because everyone understands that it couldn’t be seized anyhow.

  1. No collateral

The other issue is that a state typically needs to borrow more money than any one bank has. And a bank doesn’t want to have one(1) customer and – to make matters worse – have no recourse if that customer doesn’t pay them. Sovereign states therefore tend to borrow money by issuing bonds. Each bond tends to be rather small, maybe some multiple of $1000, or whichever currency the country uses. That because you are bound to have lots of creditors and one giant debtor – the country in question.

  1. The borrower is the big player and there are lots of smaller lenders

To differentiate things even more bonds typically have “maturation date”, which is just the term used for when a bond-holder can claim their money back. So the lender can’t foreclose on the borrower.

  1. No foreclosure

In the scenario a bond is basically a piece of paper with some nominal amount of currency that “it’s worth”, as well as a fixed interest rate.

  1. Fixed interest rate

It doesn’t say who owns the bond because they tend to be the kind which you can sell freely once you buy them so it doesn’t make sense to write some ownership on the paper. Ownership is just handled how things would normally be traded, it’s not reliant on anything being written on it.

Reverse rules

See how that’s kind of the reverse of a loan from a bank? Here the giant is the borrower of money and there are many, many small lenders; not one big lender and lots of small borrowers.

This may seem like the worst idea in the world, lending money without even the pretense of collateral, fixed interest and you have to wait until the bond “matures” to get your money back? Why wouldn’t the country just refuse to pay? Not being willing – or able – to pay the money you owe is referred to as “being in default”(even renegotiating the terms tends to be seen as a “default” technically).

The thing about that is that no one will buy your bonds if you are in default. Why would you? There exist pieces of paper where government Y has pledged to pay the bond holder some money at some date and they haven’t done that in this scenario. Why buy a similar piece of paper from them? For this reason – and a few others – countries really don’t want to default: they want to keep borrowing money.

Just to cover this as well: why not print the money or raise taxes? Printing money if very inflationary, see Zimbabwe for a country that has recently and repeatedly done that anyway and it hasn’t worked out great, as you may have noticed. Taxes? That is one of a state’s magical bullets but voters tend to react negatively when a government raises taxes so that isn’t popular either. Borrowing allows a government to avoid both boosting inflation and popular discontent.

So buying government bonds is actually a pretty safe investment and banks and insurance companies across the world are very keen on buying them. Oh – by the way – I have previously – and will in future – talk about bonds as actual pieces of paper but nowadays they are purely electronic. That doesn’t really affect the dynamics around bonds but if you have a hard time seeing someone carting off a million bonds in a big truck: yes, you’re entirely right, that isn’t done.

Government bonds are considered so safe that they are frequently seen as safer than lending to a bank. In the financial market everything is priced by risk. So in the case of governments bonds with a fixed value it is the interest rate that varies depending on how much safer people view those bonds than a deposit given to a bank. Maybe the bank offers 2% interest but the investor thinks government bonds would be safer so he accepts bonds that only offer 1% interest.

Bank runs

Now for a short-ish digression: bank runs. This isn’t literally about banks running and nowadays it’s not even about people running to the bank because it’s all electronic these days. But the name comes from people back in the day running to the bank to withdraw their money. If one depositor runs to the bank because he suddenly needs money it’s not a problem. The issue is if depositor Z is worried about losing his deposit and figures he will withdraw the money before the bank runs out. Because then every depositor in that bank will do the exact same thing. Why wouldn’t they? If they weren’t concerned that the bank would be unable to redeem all deposits before, they will be now when everyone else is running to withdraw their deposits!

This is a known problem and I think it’s best to explain two terms:

  1. Insolvent
  2. Illiquid

Insolvent is bad. It means you have more debts than assets and so can’t even theoretically pay back the money you owe.

Illiquid however only means that you can’t right now pay people back the money that you owe them. If people just wait patiently, everyone gets their money back.

Banks are rarely insolvent but almost all banks are illiquid. Their depositors can ask for their money back at like 24 hours’ notice but it take them years to turn all collateral and other assets into cash money. So as long as depositors are satisfied that the bank in solvent and don’t care about the fact that they are illiquid: all is good! This is how financial systems are set up to work. It’s not necessarily the only way to have a financial system arranged but it is the most common one. It could be argued that it’s not great that banks can have short-term liabilaties and mostly long-term assets but this is what we’re going with…

This leads to the somewhat unusual situation where what depositors believe is the difference between having a bank run and not having a bank run. If there’s a run on the bank the financial system will collapse because banks will fail to redeem deposits and typically this brings down pension funds and insurance companies and can turn the country’s currency mostly without value.

Most jurisdictions have a formally defined depositor’s insurance. The US is interesting in that the pseudo-private FDIC offers insurance to depositors in participating banks up to something like $250 000. In Europe it’s €100 000 I think. But in practice the insurance is 100% and there’s no upper limit.

In most countries governments don’t say that openly but as we saw with Silicon Valley Bank, the actual depositor-insurance is not capped. If it were then governments would need to sit and watch one bank fall, then another, then another. They would see bank after bank toppling and see it spread to other financial institutions.

So if you’re looking at the risk of a bank not being able to pay back the money you’ve deposited, that requires both the bank and the state itself being bankrupt. Lending money to the state itself is just accepting one of those risks. In Sweden SBAB is basically a bank run by the state and if you lose the money deposited with them, then holders of Swedish government bonds are also going to lose their money. Or to put in another way: SBAB won’t fail to meet it’s obligations as long as the Kingdom of Sweden has a government capable of worrying about the financial system.

Some countries have failed in this regard anyway. Sometimes because they issued bonds in a currency they can’t print – which is unsurprisingly dumb. Sometimes it’s because they are so financially screwed that there’s no point in trying to patch up the veneer of a functioning financial sector. Many countries in this position will only have one lender they can turn to: the International Money Fund. That is why the IMF is known as a Lender of Last Resort. But they are aware that lending to countries that have squandered the money they borrowed from other people, is kind of a risky proposition. So they require very clear reforms and plans for how the money is to be paid back. They catch a lot of flak for that and I argue that they have a Sisyphean job and it’s better to let countries default and clean things up as best they can, but those are just my two cents.

Yield

Anyway, so government bonds are seen as a safer investment than depositing money into a bank. Goverments do sort of pay a premium on interest for their bonds since they don’t offer collateral(because it wouldn’t be believable even if they tried to put something up as collateral) but even with this increased risk they are still seen as a safer investment than depositing money into a bank. A interesting thing does exist when it comes to the whole maturation date of bonds. If the maturation date is 20 years in the future the money with which the bond was bought is locked away for 20 more years. So for 20 years the money can’t be used for some other investment. And maybe the interest rate on normal bank deposits are higher than the interest offered on the bond? For these reasons a bond that stretch further into the future normally have high interest rates, to compensate for the risk of money being locked away for so long at a fixed interest rate. Sometimes this inversions of interest-rates for short-term and long-term bonds isn’t true and economists tends to freak out whenever that happens.

Now for a very relevant issue, that also sounds very boring: yield. Interest rate is whatever is printed on the bond itself and it is calculated against the nominal value of the bond. So let’s say we have a $1000 bond at an interest rate of 10%. That means whoever owns the bond gets $100 a year. Simple enough. But what if someone feels like it’s 50%/50% if they are going to get their money back from the government that issued the bond? They might sell their $1000 bond for $500! At least they have the money in their pocket and don’t worry about if they’re going to get $0 or $1000 back.

But what about the buyer who got the $1000 bond for $500? He still gets $100 a year! Because until an issuer of a bond goes into default the nominal value is claimed to be the true value when calculating interest. So this new owner gets a de facto 20% yield. Imagine now if that same government tries to sell new bonds at 10% interest. No one is going to buy them. All potential buyers will say “We can just buy these older bonds at half price and even though we recognize that it’s like 50%/50% if we end up getting paid in full, we will get 20% yield until then”. So the government can then only sell new bonds if they offer 20% interest.

I’ve described this kind of like an auction and while an electronic auction typically is held when new bonds are being issued, the government doesn’t have to wait until an auction to find out what interest rate they have to offer. They can just look at what the yield is on their older bonds. They aren’t stupid, they understand full well that they can’t offer half the interest rate of what you would actually get if you bought an older bond. So for any country the interest-rate they need to offer for various bonds that mature at various dates into the future is known at every minute at every day by looking at the yield.

Confidence

This can lead to problems. This isn’t unheard of: investor A isn’t sure country Y will be able to pay him back. He sells his bonds for 90% of the nominal value. The yield rises by 10%. Investor B isn’t sure that country Y will be able to pay him back, so he sells his bonds for 80% of the nominal value and the yield rises proportionally. Investor C wasn’t concerned before but now he’s seeing yields that country Y certainly can’t pay so he sells his bonds for 70%. And so on, and so on. All investors lose some amount of money and outside observers will have a hard time seeing a different cause of this financial loss other than the very same investors that took the loss.

This would be considered pathological behavior for an individual but investors in bonds – issued by governments or corporations – are not united, they are usually competitors who don’t trust each other for five cents, and for good reason. This is none the less a concern for countries, they know that enough investors losing confidence in the country’s ability to pay its debts is enough to drive the state into bankruptcy. It doesn’t matter if there is an actual reason for a loss of confidence, the country still ends up bankrupt. So making your ability and willingness to pay back your debts abundantly clear is very necessary for countries.

An objection might arise here: isn’t this undemocratic? Yes. Yes, it is. This whole thing makes whoever has lent the most money to the government most powerful. It’s no longer just “one man->one vote”, it’s also “one bond->indeterminate control over public affairs”. But governments across the world have chosen to make creditors kingmakers. Creditors originally had no say in the matter and it is only by borrowing more and more money that governments have given creditors a position to call the shots.

So if a government wants to take authority away from creditors and give it to the people: they can do so. They just have to pay back the money they owe. I can only think of one country that did that – Romania – and they completely screwed up their economy so it’s hard to hold that up as a glowing example. In general any politician thinking about reducing the country’s public debt imagines what will happen in the next election if they raise taxes by 3% and then they go on to borrow more money and kick the can down the road. Is that good or bad? That is for each voter to decide but this is how things work in most countries.

Macroeconomics

This is a sort of behind-the-scenes aspect of what is going on in the US, France and South Korea. It’s not just “what did the voters demand in the previous election”, it’s also “how do we keep borrowing money”. Liz Truss seems not to have understood that during her time as Prime Minister or after, which is kind of amazing. Even I know “Let’s spend £25 billion and I am not even going to check if someone will lend it to us” is a bad idea.

I may make it sound like Sovereign Debt is bad but how would a bank, an insurance company or a retirement savings company invest their money if they could buy government bonds? By shares from private companies is the typical offered alternative but does $100 million at Conglomco really yield significant returns? A government borrowing money and spending it on serious investments like power plants, rail roads and universities that yield significant returns is a very sensible way for savings to be handled.

A country like Sweden metaphorically burnt its hand on Sovereign Debt so has really low levels of government debt but on the plus-side we don’t have a big bill to pay for interest rates. And we see a lot of other countries in the West have the problem that they now really need to borrow money but they already exhausted the government’s ability to do that by borrowing money to pay for running expenses that they had no business funding with loans.