Why Sovereigns Default on Local Currency Debt

I’ve had a number of emails and comments this morning on this report from Fitch titled “The money printing myth – why sovereigns default on local currency debt”.  So here’s my view on their paper.

First of all, an MRist should never say that a monetarily sovereign currency issuer can’t default.  One of the key points behind MR is flexibility and specificity with regards to certain monetary systems.  I tend to focus on the USA and have repeatedly said the USA won’t default.  But that’s a very specific case based on a very specific understanding.  Generalizations can be extremely dangerous in the world of economics where there are so many complex moving parts inside the various systems.

We have to be more careful to look at each instance as its own unique occurrence.  For instance, writing long research reports that compare the sovereign debt of ALL countries over the last 100 years and then concluding that 90% debt to GDP is dangerous for all of them, is highly misleading as it doesn’t get granular enough in understanding how that sort of data applies to each monetary system.

For instance, when someone compares the USA to Greece they’re comparing a low output currency using nation to a high output currency issuing nation.  You have to be more detailed than just making vague generalizations.  The details matter!  So what does Fitch’s report tell us?  Well, it shows us that sovereigns most certainly can default on their local currency.  The ability to print your own currency is not always a fix to get out of an economic rut.

The point is, money is not a substitute for having domestic resources, output, etc.  MR focuses a great deal on the quality and stability of output because that’s ultimately what money is used for. Money is not the end.  It is merely the means to an end.  Remember, if money is merely a ticket to enter the theater that is a specific economic “show” then the ability to print more tickets does not automatically mean you can increase demand for the show (it might, at times, but certainly not always!).  If the show is worthless the tickets are worthless regardless of whether you have the ability to make more tickets or not.  The ticket printer isn’t always the solution to the problem!

So that brings us to the point of internal and external constraints.  The Fitch report doesn’t point out that many of the nations cited in their study were on a fixed exchange rate system when they defaulted.  This currency arrangement is essentially a foreign debt situation.  So why would a country ever peg its currency to someone else’s?  Well, not all countries are like the USA with a strong export and import base and a currency that is accepted everywhere.  So it can be advantageous at times for a country to fix its exchange rate to boost growth.  There are plenty of examples of countries who peg their currency to try to boost competitiveness.  Some might call this irrational, but the alternative is the potential suffering of economic growth in the near-term.  Again, the case of American exceptionalism shouldn’t be generalized to all other countries.  I’ve written quite extensively about some of the cases Fitch cites (for instance, see Russian analysis here) and you can clearly see that there are more parts to the puzzle than simply defaulting on domestic debt.  You have to get granular with this stuff.

The bottom line is, all countries can’t be truly sovereign in the same sense that the USA is.  There are real constraints.  And that brings us to a very interesting comment from a friend of mine who works in international banking in South East Asia who works for one of the biggest banks in the world and specializes in selling debt to foreign central banks.  I recently asked him why a country might be inclined to borrow in foreign denominated debt thereby relinquishing their sovereignty.  He said:

“Many countries have to borrow dollars for both internal and external purposes. If their currencies are not freely convertible currencies and/or are not accepted by the other party or parties in payment for goods or services, the country has to borrow dollars to meet such obligations. If the country generates dollars, euros, yen, sterling, swiss francs, etc. from its exports, then it may not need as much in borrowings as those who do not. A good example is virtually any oil based economy. They generate huge amounts of dollars that are then used for infrastructure projects lie roads, dams, power plants, housing, etc. These projects are predominantly undertaken by foreign contractors and they want to be paid in dollars or yen, etc.

At the same time, countries have to have foreign exchange available to meet the demands of their corporations and to a much lesser degree their populations. When a company needs to buy product or raw materials or pay for services rendered that are priced in dollars, they need to buy that foreign currency from their local banks who in turn, have to buy from the Central Bank or another bank that will buy the local currency against the foreign currency.

Now the Philippines is an exporter of rice, textiles, furniture, labor (loads of maids, nannies, construction workers and ship crews to other parts of Asia and the Middle East), etc. which generates dollars but not enough to pay for all the projects undertaken by an expanding Lesser Developed Country (LDC). Same was true and remains true for most developing countries today. So they need to go out and borrow Balance of Payments or Infrastructure loans from the IMF, the World Bank, the private market (like the international bank markets and the bond markets) to source their foreign exchange.

I’d also add that it’s not strategically viable to avoid a fixed exchange rate policy at all times. Many LDCs are essentially forced to run a fixed exchange rate because their domestic economy is not strong enough. They can’t attract foreign investment so printing money is out of the question since it would simply cause high inflation. So they peg their currency to a stronger trade partner, attract investment, and can achieve higher growth levels without much of the inflation worries that would arise from just printing money. In other words, they don’t have the supply of goods to sell to their own domestic economy so they essentially import the goods (temporarily) produce them domestically, attract the investment, wages and jobs and then export the goods. This approach is the only viable growth option for many LDCs.”

Not everyone has the luxury of a diversified economy that exports the GDP of Russia every year (as the USA does).  So we have to be careful with these generalizations.  Can a sovereign currency issuer default on their domestic debt or run into severe internal or external constraints – you bet your ass they can.  Are there times when a country might be forced into borrowing a foreign currency because of inherent constraints?  Yes.  So the specifics matter and we should be careful about extrapolating generalities out across the entire spectrum of monetary systems in the word.  No two systems are exactly the same….In my opinion it’s wrong to state that a sovereign currency issuer can never default.  But it’s equally misleading to imply that all debt is the same across all countries.  The details matter.