Sovereign Debt

What is Sovereign Debt?

Sovereign debt is the amount of money the government of a nation has borrowed from creditors. It is also termed government debt, national debt, or public debt.

The single difference between government and sovereign debt is that government debt is issued in domestic currency, whereas sovereign is issued in foreign currency. Typically US currency is used for international debt payments as it is considered the most stable currency and mitigates risk.

Accumulating debt has benefits as it is used to fund a budget deficit on services considered healthy for the economy, such as building infrastructure, educating the new generation, providing benefits to the most vulnerable, and subsidizing innovation.

These are some of the components that can increase a nation's productivity. In addition, a greater level of employment can result in more significant government revenue, potentially exceeding the fiscal budget forming a surplus, and allowing a country to grow past its debt, in theory.

Government Revenue

The government accumulates money by taxing the nation on what they earn (income tax-related), buy (VAT, etc.), and own (property tax, etc.).

These funds will be proposed to pay for services that benefit the nation or the disadvantaged population because taxes target wealthier individuals who earn, buy, and own more than the majority.

Tax is made progressive, meaning that the higher income earners are placed in higher tax brackets for the underlying income within the frame to be taxed at a higher rate. This system is thought to reduce the social ills appropriated with income inequality.

Revenue can be obtained amongst different government authorities.

• Federal tax encompasses the nation and relies on its Internal Revenue System (IRS) to enforce tax laws correctly. At the national level, income tax is the primary revenue source.
• Municipal tax refers to the tax imposed by local or state government authorities, which rely heavily on other forms of taxation apart from income to generate revenue, such as property tax, road tax, and sales tax.
• These taxes can vary in different states depending on their infrastructure and dependence.
• Tax benefits reduce government revenue by a significant amount and are accounted as government expenditure. This allows individuals and corporations to pay less tax as it is deducted from their tax returns.

It is directed towards business expenses and companies with advantageous properties which benefit the economy or the world, an example being a low carbon emission company that can pay less tax for their environmentally friendly efforts.

However, taxes are insufficient as the government spends more than they take, making government bonds available to the public and the wider world as an investment tool and for a country's sustained growth, creating a win-win scenario.

Acquiring debt relieves governments from raising taxes or reducing expenditures to keep within a budget, which would upset many people. Instead, debt allows more projects to be funded simultaneously for all districts to benefit.

Government Debt

The creation of debt securities issues government debt. The US Treasury publishes them in the form of Treasury Bonds which span from weeks to months to years in maturity.

Short-term maturity loans are referred to as Treasury bills, whereas, longer-term loans are classed as treasury notes and bonds.

The principal value of the bond is paid to the creditor at maturity, and regular interest payments, also known as coupon payments, are determined by the bond's yield and are made at precise intervals.

For example:

• purchasing a bond at face value of $1,000,
• with a yield of 5% for 10 years,
• would return a total of $1,500 at maturity.
• This includes the principal value of $1,000 and coupon payments of $50 each year at designated intervals.

The yields typically reflect the interest rates of the overall economy as the main risk of lending money to the government is the devaluation of the currency over time caused by inflation.

It is considered the most risk-free investment as the bonds are backed by the government, which will prioritize coupon payments and avoid a default at any cost, as it would threaten the stability of their economy.

The US is said to have the safest bonds, as the country and its economy are relatively stable, and the US dollar is held as a foreign reserve currency by most countries showing the trust behind its value.

If the US were to default on its debt, which is unimaginable, it would be catastrophic worldwide.

US bonds are considered low-risk, but they return low-interest rates compared to equity and corporate bonds, which carry more risk.

Bonds are auctioned to underwriters and financial institutions in the primary market to the highest bidder. The bonds are either retained by financial institutions or sold to investors on the secondary bond market.

These bonds are typically utilized in mutual funds and pension funds to secure growth for investors and hedge risk.

Bond Market

Countries such as China and Japan have acquired a relatively large percentage of US Treasury bonds as a safe investment to maintain the value of their US dollar foreign reserves. This is partly due to both countries being large exporters to the US and therefore have built up a large fund.

Financial institutions use repurchase agreements (Repo) to access quick liquidity overnight to finance daily operations.

Treasury bonds, the safest debt instrument, are used as collateral for the agreement, with the bond buyer being the lender who sells it back to the borrower at a high price as interest.

The Federal Reserve is active in open market operations to ensure enough liquidity within the repo market. The buying of treasury bonds from the open market ensures there is an availability of cash for financial institutions to stimulate spending and growth.

Congress established a debt ceiling to restrict the amount of outstanding debt held by the US over a period. The US Treasury can issue bonds until the limit is reached and must finance payments using alternative methods.

The ceiling has been raised during times of urgency to avoid the prospect of default, which would cause US interest rates to increase drastically as of elevated risk.

A sequence of catastrophic events would follow a default as the international financial markets rely on US treasury bonds for many global operations.

Fiscal policies have allowed the debt ceiling to be raised, which currently sits at $31.4 trillion since Dec. 16, 2021.

An increase of $2.5 trillion from the previous limit. The capacity adjusted for public spending drives economic growth and development in hopes that output exceeds input to reduce government deficit/debt.

Government Spending

The primary objective of government spending is growth and development. Various sectors serviced through government spending are education, healthcare, defense, social welfare, science, and many more.

Spending focuses on two goals,

• to accommodate the current population’s requirements, primarily social welfare, and
• to promote future advancement by developing infrastructure and financing aspiring sectors, such as education, for future employability.

Mandatory spending is constructed through the law to ensure that disadvantaged individuals are provided relief through entitlement programs; for example, low-income families benefit from healthcare relief and food stamps.

The budget for mandatory spending has no limit, expanding to be inclusive to all underprivileged nationals who fit the criteria.

In the appropriation process, discretionary spending is conversed by Congress to determine a budget and what sectors to allocate portions of the budget. For example, the US dedicates most of its budget to the military for national defense.

The first form of bonds was issued to fund the Revolutionary War in the 1790s, then evolved into a tool for domestic development.

Principal and interest payments for existing government debt can be paid off through the issuance of new debt, preventing the likelihood of default as the government can borrow more.

The Treasury can also refinance debt by issuing bonds with lower interest to replace debt with a higher interest.

These processes allow the treasury bond market to remain sustainable.

Tax breaks for corporations and individuals are classed as tax expenditures for the government, as it reduces the amount of tax paid.

As of 2020, tax expenditures cost the US government $1.3 trillion, almost resembling discretionary spending. Lawmakers craft tax codes to specify who can redeem the benefit and under what conditions.

Tax relief primarily benefits the wealthy as they are the most significant tax contributors. Retaining more money encourages spending and business expansion, stimulating the economy.

The tax codes can favor specific industries to adjust the direction of companies, for instance, relief for companies that display environmentally-friendly measures or a low carbon footprint.

Is Too Much Debt Bad?

When a government spends more than its economic output, gross domestic product (GDP), it is at more risk of accumulating debt to finance its budget deficit.

A proportion of GDP accounts as tax revenue to the government; therefore, a higher GDP would allow the government to accumulate more payments.

A government aims to achieve a higher level of prosperity by investing resources and infrastructure within its own country for long-term growth and development.

The theory is that growth would increase GDP, which would eventually exceed the national debt, and the government would be able to make repayments.

However, the rate at which debt accumulates in the US is faster than the growth of the American population.

If the debt continuously grows and reaches new highs, it is perceived as becoming riskier as it will be harder for the country to pay off its debt.

More risk would require higher bond yields, placing a greater burden on the government to make payments as they would annually borrow more to make existing debt repayments.

High yields would be reflected in other forms of debt within the country, such as interest rates for corporate debt and mortgage rates to compete with the significant returns from government bonds.

This would limit businesses from acquiring the necessary finances to handle daily operations, reducing revenue and future investments.

It would require them to increase the price of their goods and services to remain profitable, which causes inflation pressures on consumers, or they may downsize their business by laying off employees, which are both negative economic factors.

Alternative measures to alleviate debt could include introducing higher tax rates or cutting public expenditures. However, this would be unfavorable as living standards would downgrade, and people would lose faith in their government.

Trade balance

Foreign trade is an important factor for the debt if a country is running a trade deficit, meaning they are importing more goods and services than they export, which leads to more money leaving the economy.

Countries promote imports when

• the economy is overheated to encourage competition and tame inflation.

On the other hand,

• exports stimulate the economy as more goods are sold, and jobs are created.

A trade deficit may advise a country to borrow money from foreign countries to help finance domestic development. For example, China and Japan are major exports of goods to the US and generally produce a trade surplus.

These transactions often cause an abundance of US dollars in China’s and Japan’s economies, which the government seeks to exchange for the national currency.

USD is kept as a foreign exchange reserve from which US treasury bonds are bought to prevent the reserve from devaluing.

The US had the largest trade deficit of all countries in 2019.

Debt-to-GDP Ratio

The Debt-to-GDP ratio is a widely used indicator of a country's ability to pay its debt obligations. By comparing debt and GDP, you can estimate how many years the country will be able to cover its debt solely through GDP.

The metric is measured as a percentage, with above 100% indicating the country is in more debt than GDP, perceived as an increased risk of default.

The World Bank has calculated a decline in economic GDP begins when the ratio is above 77% for developed countries and lower for developing countries.

Japan has the highest debt-to-GDP ratio; however, it is disparate as the citizens own the majority of the debt domestically.

Highest Debt-to-GDP ratio countries (2022):

1. Japan - 257.75%
2. Greece - 222.37%
3. Italy - 183.49%
4. United States - 150.36%
5. France - 145.81%
6. Portugal - 145.47%
7. United Kingdom - 142.99%
8. Spain - 142.51%
9. Canada - 130.31%
10. Belgium - 127.77%

European Debt Crisis

The European debt crisis began in 2008, initiated by the collapse of Iceland’s banking system, and impacted various European countries, primarily Portugal, Ireland, Italy, Spain, and Greece, in 2009.

The crisis caused the collapse of financial institutions, crippling government debt, and surging government bond yields. As a result, European businesses and economies lost confidence and foreign investors.

During the dilemma, Greece, Ireland, and Portugal had their sovereign debt reduced to junk bond status by international credit rating agencies.

Conspiring events that led to this disaster were the Great Recession of 2008-2012 following the financial crisis and property bubbles in a plethora of other countries.

Fiscal policies associated with government expenditures and revenues emphasized the cause. Greece announced the prior government authority had significantly underreported its budget deficit, which was a violation of EU policy.

This pressured a euro collapse through the fault of government incompetency.

In late 2009, Eurozone member states of Ireland, Cyprus, Greece, Portugal, and Spain had acquired substantial government debt with no processes of repaying or refinancing, as well as a lack of funding to bail out their distressed banks without the support of third-party financial authorities.

The intervention involved the European Central Bank (ECB), the International Monetary Fund (IMF), and the newly formed European Financial Stability Facility (EFSF) to prevent the complete collapse of the Euro and economic integrity.

Loan agreements were reached, providing financial aid to impacted countries under the condition that those countries enforced austerity measures to compensate for the growth in national debt.

As fears increased around the extensive sovereign debt, lenders demanded higher interest rates for the imposed risk. Excessive debt and deficit levels were burdensome for countries to finance during low economic growth.

In response, countries raised taxes and reduced expenditures, provoking social unrest and a lack of faith in the government, particularly in Greece, leading to sovereign default in June 2015.

Greece’s default was solely from their government's negligence in maintaining a stable economy. Tax evasion was rife, and Greece, a member of the European Monetary Union (EMU), relied significantly on borrowing finance to fund its budget deficit, which was exacerbated due to low revenue.

Despite funding availability, Greece displayed little development in trade and economic output. Moreover, the Euro, a domestic currency for multiple countries within the union, failed to promote competitiveness as its value remained strong and suppressed Greece's exports.

Greek nationals voted against a bailout and the imposed austerity measures, raising speculation that Greece could depart from the EMU indefinitely.

However, indications of recovery over the following years demonstrated Greece’s economy could be repaired and remain part of the EMU. Unemployment reduced from 27% to 16% over five years, accompanied by a future GDP evaluation of over two percent during the same period.

Researched and Authored by Rohan Hirani | Linkedin

Edited by Aditya Murarka | LinkedIn

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