THINK TANK | No Time To Wait : A Mountain of Debt and Vulnerabilities
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THINK TANK | No Time To Wait : A Mountain of Debt and Vulnerabilities

By Richard Gitlin and Brett House 

The need to improve the tools we use to deal with sovereign debt crises has been made particularly urgent by the accumulation of massive public debt stocks and balance sheet vulnerabilities in the wake of the 2008 financial crisis and the 2010 euro-zone crisis (Dobbs et al. 2015).

THINK TANK | No Time To Wait : A Mountain of Debt and Vulnerabilities
Following the failures of Bear Stearns in 2007 and Lehman Brothers in 2008, central banks and finance ministries pumped massive amounts of liquidity into credit markets to prevent their breakdown. Concerns raised about Greece’s solvency in late 2009, and weak activity in many other real economies, resulted in further application of exceptional monetary and fiscal measures in the ensuing years. As the Bank for International Settlements (BIS) highlights (BIS 2014a; 2014b), private debt issuance more or less ground to a halt in 2007 and public debt then expanded massively, taking the global debt securities market from just over US$60 trillion in 2007 to about US$100 trillion by 2013 (see Figure 1).
Figure 1: Global Debt Securities Market (in US$ trillion)

The mountain of sovereign debt created in recent years leaves little room to cushion the impact of a policy mistake or respond to a new exogenous shock.Global vulnerabilities extend far beyond Europe’s continued saga with Greece. The aggregate debt-GDP ratio for all advanced countries has returned to historic highs above 100 percent (Figure 2) — a level that in the past has been associated with heightened geopolitical tensions, liquidity problems and insolvency (Reinhart and Rogoff 2009; 2011; 2013; James 2014). 

Figure 2: Global Debt-GDP Ratios (in percent, unweighted ratios)

 Figure 2: Global Debt-GDP Ratios (in percent, unweighted ratios)

This situation is not set to reverse itself quickly. Globally, real activity is not rebounding strongly as fiscal stimulus ebbs and investment in public infrastructure falls to new lows (Summers 2015; Wessel 2015), despite IMF (2014d) evidence that every dollar of well-planned public investment can increase total output threefold. More than 20 central banks have returned to cutting interest rates and easing monetary conditions (BIS 2015; also see Table 1). Whether these are genuine responses to weakness in domestic economies or cloaked attempts to devalue against the US dollar in a diffuse currency war, uncoordinated monetary easing of this sort raises the possibility of beggar-thy-neighbour trade protectionism that could cut global growth prospects further (Rajan 2014).

 Table 1: A New Round of Central Bank Rate Cuts

Table 1: A New Round of Central Bank Rate Cuts

Medium-term secular trends imply that heavily indebted developed-economy sovereigns will not find the years ahead much easier. A gathering imperfect storm of insufficient stimulus measures, impaired credit-creation mechanisms, deleveraging across a range of sectoral balance sheets (Koo 2014) and aging populations could entrench secular stagnation (Summers 2013; 2014a; Lagarde 2015a) and make real debt burdens even more onerous across advanced economies. The GDP denominator in high debt-GDP ratios is unlikely to bring down these ratios any time soon. At the same time, there’s little room to pare the debt numerator. 

The IMF (2011b) shows that, ceteris paribus, many advanced countries would need fiscal surpluses well in excess of recent decanal averages in order to bring debt-GDP ratios down to 60 percent of GDP from their existing levels over the next 10 years. Where countries have prepared plans to achieve such surpluses, they will be technically and politically difficult to execute, as Barry Eichengreen and Ugo Panizza (2014) underscore. Moreover, if all or even most advanced countries target fiscal austerity at the same time, global growth prospects would be dented further and revenue projections would likely not be realized. 

The Organisation for Economic Co-operation and Development (OECD) (2013) and IMF (2014b) have projected primary deficits in the neighbourhood of 3.5 percent of GDP over the next five to 10 years, as age-related health, long-term care and pension spending are set to expand by an average of between 5.5 and 10 percent of GDP in advanced economies (IMF 2012c; 2014a). Running these projections through a basic model built on the IMF’s debt sustainability analysis (DSA) template implies that advanced-country debt-GDP ratios could continue to rise to over 120 percent of GDP by 2030 (see Figure 2).

Past experience implies that at these debt levels advanced sovereigns would likely face substantially increased risks of default. As Carmen Reinhart and Kenneth Rogoff (2009) show, sovereign debt restructuring has historically been more the norm than the exception: in nearly any given year over the last century, some country has been in default or in the process of restructuring its debt. At current and expected advanced-country debt levels, sovereign debt crises look nearly inevitable when set against past developments. 

Of course, it’s possible that some combination of tougher capital adequacy standards under Basel III and related local legislation will stoke demand for near risk-free assets and sustain bids for new sovereign debt issuance. But it would be deeply imprudent to orient international economic policy making around this faint hope. Moreover, as demonstrated by the recent crises in Iceland, Ireland and Spain, and the late-1990s Asian crisis before them, private-sector debt problems and balance sheet mismatches can quickly morph into sovereign debt problems. National accounts likely understate the extent to which corporate foreign-currency borrowing has expanded through issuance in the domestic markets of overseas subsidiaries (Shin and Zhao 2013; Wheatley 2014; Nordvig and Fritz 2014). To paraphrase Reinhart and Rogoff, the next time is unlikely to be different.

The fact that much of the recent run-up in advanced country debt is linked to domestic issuance should provide limited comfort. Although domestically denominated debt can be inflated away, and debt issued under domestic law is typically easier to restructure than foreign-law debt, domestic debt can still be a source of substantial vulnerabilities (Panizza 2007), although these weaknesses may be less pronounced than those engendered by foreign currency and foreign-law debt (Dell’Erba, Hausmann and Panizza 2013). Cross-sector and cross-border maturity and currency mismatches in private and public domestic debt stocks can expose sovereigns to substantial risks, some of which precipitated sovereign debt crises in the late 1990s and early 2000s, as detailed by Christoph Rosenberg et al. (2005).

One of the few ways in which the next set of sovereign debt crises could genuinely be different is in the much wider range of countries that could be involved. Several relatively poor countries, rebranded as “frontier markets,” have in recent years made their debut issues on international capital markets with offerings that have been multiple times oversubscribed as investors eschew meaningful distinctions in credit quality in their search for yield. Ghana was able to issue an oversubscribed US$1 billion bond in September 2014, one month after its decision to seek help from the IMF. Even Ecuador returned to capital markets in 2014 after capricious unilateral defaults in 2008 and 2009 on international obligations it considered “illegitimate.” Until 2006, South Africa was the only Sub-Saharan African country that had issued an external sovereign bond. Since then, 12 Sub-Saharan African countries have issued more than US$17 billion in external bond debt (see Table 2); three more countries have made private external placements during this time: Mozambique and Angola (2012), and Tanzania (2013). 

Table 2: African Frontier Market External Debt Issuance (excluding private placements)
Table 2: African Frontier Market External Debt Issuance (excluding private placements)

Eight of these African countries had most of their external debt written off only a few years earlier under the HIPC and Multilateral Debt Relief Initiative (MDRI) restructuring programs. Some of these countries are indeed much more credit worthy than they were even a decade ago: democratic governance, economic performance and natural resource management have improved markedly in many of them. But all frontier markets face a substantial risk that they will encounter higher interest rates when it comes time to roll over their recent bond issues. Even now, some 40 poor developing countries, many of whom benefited from HIPC and MDRI debt relief, are in medium to severe debt distress (Table 3; IMF 2014e; Kaiser 2014). The next debt crisis is already brewing.

Table 3 : Incipient Sovereign Debt Distress in  Heavily Indebted Poor Countries (HIPC)
Table 3 : Incipient Sovereign Debt Distress in 
Heavily Indebted Poor Countries (HIPC)

The end of US quantitative easing (QE) and signals of a coming Federal Reserve rate increase make efforts to improve the non-system of sovereign debt restructuring particularly time sensitive (Chung et al. 2014). Although there is evidence that good policy regimes provide some insulation against taper-induced pullbacks (Mishra et al. 2014), the “taper tantrum” of 2013 tended to hit emerging markets indiscriminately (Eichengreen and Gupta 2013) and, in some cases, countries with better policy frameworks saw relatively larger outflows as these economies also tend to have the most liquid, easily exited markets. 

Looking at earlier rounds of Fed tightening, Joseph Capurso (2014) notes the collateral damage on emerging markets is often most intense about one year after Fed policy has been made less accommodative, particularly in countries with large current-account deficits and banking systems particularly dependent on foreign wholesale financing. The Institute of International Finance’s (IIF’s) models anticipate three or four emerging-markets crises each year in which the US Fed tightens monetary policy, up from the 40-year average of 1.7 crises each year (IIF 2015). The BIS (2014b) has already sounded warnings about the impact of higher US yields and a stronger dollar on global debt stocks. In March 2015, the IMF’s managing director, Christine Lagarde (2015b), cautioned that the 2013 tantrum was not a one-off episode and called on both advanced and emerging economies to get prepared for increased volatility ahead.

Solving the financing problems of emerging markets ultimately requires better domestic policy regimes to win the confidence of their own investors: improvements in debt restructuring systems deal with symptoms rather than the root causes of sovereign debt distress. Over long spans, the world’s main concern shouldn’t be temporary pullbacks during yield increases in the United States, but rather the secular tendency for capital to flow in the wrong direction between advanced and emerging economies: more capital consistently heads out of emerging markets than into them. Rather than a home bias, emerging-market public investors, in particular sovereign wealth funds and central bank reserve managers, tend to maintain a foreign bias that goes hand-in-hand with the ongoing stain of “original sin,” the inability of many emerging-market sovereigns to borrow domestically or abroad over long tenors at fixed rates in their own currency (Eichengreen, Hausmann and Panizza 2002; 2007). 

Capurso (2014) notes that emerging market public investors’ assets under management rose from US$3 trillion in 2007 to US$11 trillion in 2012, with most of this devoted to advanced economies. The roughly US$8 trillion in flows from emerging markets to advanced economies allocated by emerging market asset managers from 2007 to 2012 was about 10 times greater than the US$0.8 trillion in developed-market flows pushed by the search for yield into emerging markets during this five-year span. Any improvement in sovereign debt restructuring regimes should, therefore, be accompanied by better ongoing domestic economic policy making in emerging markets, rather than continued pressure on the IMF to endorse capital controls (IMF 2011a; 2012a). 

About The Authors:

Richard Gitlin joined the Centre for International Governance Innovation (CIGI) as a senior fellow in June 2013. He played a leading role in the development of practices and procedures for successfully resolving complex global restructuring and insolvency cases. Richard has served as adviser to several countries regarding the modernization of their insolvency laws, including Canada, Korea, Indonesia, Mexico and the United States, as well as the International Monetary Fund (IMF) in connection with corporate and sovereign restructuring reform.

Brett House is a senior fellow at the Jeanne Sauvé Foundation and a visiting scholar at Massey College, University of Toronto. He is also an adviser at Tau Investment Management, a startup impact fund. This special report was initiated during his tenure as a senior fellow at CIGI. 

Publication Details:

This work is an extract from "JUST ENOUGH, JUST IN TIME Improving Sovereign Debt Restructuring for Creditors, Debtors and Citizens" (Special Report) by Richard Gitlin and Brett House. Download the Report - LINK

This work is licensed by the Original Publisher – Center for International Governance and Innovation, under a Creative Commons Attribution — Non-commercial — No Derivatives License. To view this license, visit ( licenses/by-nc-nd/3.0/).