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Emerging economies are increasingly moving from external to domestic debt. Conventional
wisdom says that this is an improvement that signals a lower risk of sovereign default. But
this column presents evidence that history disagrees and argues that defaults are likely to
persist. Yet, alas, apparently unknown to most observers in financial, academic, and policy
circles, domestic debt has been around for a quite a while. For that matter, so too has been
default on domestic debt of one form or another. In our latest paper, Kenneth Rogoff and I
unearth a vast trove of historical time series data on external and domestic public debt for 64
countries ranging back to 1914.2 Our key sources are publications of the now-defunct
League of Nations, updates by its successor, the United Nations, and the work of many
scholars and government agencies.
First, domestic debt is and was large for the 64 countries for which we have long time
series, domestic debt averages almost two-thirds of total public debt; the increase in the
share of domestic debt in the last few years is but an upward blip in the larger context. For
most of the sample, these debts typically carried a market interest rate, except for the era of
financial repression after World War II. From 1914 through the 1960s, before inflation
became a widespread phenomenon, more than one-half of domestic debt was long term,
even for Latin America.
Domestic debt may also explain the paradox of why some governments seem to
choose inflation rates far above any level that might be rationalised by seignorage
revenues levered off the monetary base. (This was the puzzle first pointed out in Cagans
classic 1956 article on post-war hyperinflations.)4 Although domestic debt is largely ignored in
the vast empirical literature on high and hyper-inflation, we find that there are many cases
where the hidden overhang of domestic public debt was at least the same order of
magnitude as base money, and more often than not, a large multiple, as shown in Figure 3.
Where there are domestic debts there is also domestic default. Our paper offers a first
attempt to catalogue episodes of outright defaults on and reschedulings of domestic public
debt across more than a century. This phenomenon appears to be somewhat rarer than
external default, but far too common to justify the extreme assumption that
governments always honor the nominal face value of domestic debt. When outright
default on domestic debt does occur, it appears to occur under situations of greater duress
than for pure external defaults both in terms of an implosion of output and marked
escalation of inflation. As shown in Figure 4, in the run-up to a default on external debt, the
economy is stagnant or in recession (on average, real per capita GDP edges down slightly
from its level four years before the crisis); on the eve of domestic default, however, the output
contraction is much deeper, as GDP registers an average decline of about eight percent.
It is important to note that we do not here catalogue episodes of major de facto partial
defaults, say through a sharp unexpected increase in financial repression (e.g., of the type
China still imposes today).
Comments on the paper
Domestic public debt is issued under home legal jurisdiction. In most countries, over most of
their history, it has been denominated in the local currency and held mainly by residents. By
the same token, the overwhelming majority of external public debtdebt under the legal
jurisdiction of foreign governmentshas been denominated in foreign currency and held by
foreign residents.
It should also be noted that until the past ten to fifteen years, most countries external debt
was largely public debt. Private external borrowing has become more significant only over
the past couple decades; see Prasad et al. (2003).
Why would a government refuse to pay its domestic public debt in full when it can simply
inflate the problem away? One answer, of course, is that inflation causes distortions,
especially to the banking system and the financial sector. Sometimes, the government may
view repudiation as the lesser evil. The potential costs of inflation are especially problematic
when the debt is relatively short term or indexed, since the government then has to inflate
much more aggressively to achieve a significant real reduction in debt service payments. In
other cases, such as the United States during the Great Depression, default (by abrogation
of the gold clause in 1933) was a precondition for reinflating the economy through
expansionary fiscal and monetary policy.
Of course, there are other forms of de facto default (besides inflation). The combination of
heightened financial repression with rises in inflation was an especially popular form of
default from the 1960s to the early 1980s. Brock (1989) makes the point that inflation and
reserve requirements are positively correlated, particularly in Africa and Latin America.
Interest rate ceilings combined with inflation spurts are also common. For example, during
the 19721976 external debt rescheduling in India, interest rates (interbank) in India were 6.6
and 13.5 percent in 1973 and 1974, while inflation spurted to 21.2 and 26.6 percent. These
episodes of de facto default through financial repression are not listed among our de jure
credit-event dating. Only to the extent that inflation exceeds the 20 percent threshold we use
to define an inflation crisis, do they count at all.
Indeed, a recurring paradox in this literature is why governments sometimes seem to inflate
above and beyond the seignorage-maximizing rate. Many clever and plausible answers have
been offered to this question, with issues of time consistency and credibility featuring
prominently. We submit, however, that the presence of significant domestic public debt may
be a major overlooked factor, especially consideringas we have already discussedthat a
large share of debt was often long term and non-indexed.
Precise calculations of how much governments gained by inflating down the real value of
debt require considerably more information on the maturity structure and interest payments
than is available in our cross-country data set. One also needs to understand bank reserve
requirements, interest rate regulations, the degree of financial repression, and other
constraints to make any kind of precise calculation. But the fact that domestic nominal debt is
so large compared to base money across so many important high-inflation episodes
suggests that this factor needs to be given far more attention in future studies.
Ideas on monetization and inflation
Twenty years ago there was much talk of bond vigilantes who would respond to
irresponsible fiscal policies by forcing up the interest rates on government debt. With the
bond vigilantes on the prowl, any short-term real loss suffered by investors would be
recouped in the form of higher real rates as the governments debt was refinanced.
But by buying bonds in the name of quantitative easing, central banks are influencing
interest rates of all maturities these days. By holding down bond yields, the authorities are
employing a policy some have dubbed financial repression, in which real returns on
government debt are reduced. The idea is to make investors buy riskier assets, such as
equities and corporate bonds. In effect, the bond vigilantes have been neutered.
One way of protecting the real value of investors bond holdings is to buy inflation-linked
debt. The repayment value and interest payments on such bonds are normally tied to a wellknown inflation index. But even these bonds may not be completely risk-free; it is possible to
imagine that future governments may find ways to redefine the inflation measure for their
own benefit. And foreign buyers of inflation-linked bonds are still at risk from currency
depreciation.
Inflation-linked bonds are extremely attractive to pension funds, since they are a neat match
for the funds liabilities. So such bonds are snapped up quickly and tend to trade on low real
yields; sometimes, those yields are even negative. An asset is hardly risk-free if it guarantees
a real loss.
The concept of a risk-free asset is quite useful in finance. For a start, it provides the base
from which other assets can be priced. Corporate borrowers pay an interest premium over
the risk-free rate; equities have offered a higher long-term return than government bonds to
reflect their higher risk. But what is the true risk-free rate? Multinational companies can
borrow at a lower rate of interest than some governments: compare Apple with Greece, for
example. And although America is the worlds biggest economy, its government does not
borrow at the cheapest rate on the planet: Japanese yields have been lower for many years
and German long-term yields are now significantly below those of Treasuries.
Monetizing debt[edit]
Effects on inflation[edit]
When government deficits are financed through debt monetization the outcome is an
increase in the monetary base, shifting the aggregate-demand curve to the right leading to a
rise in the price level (unless the money supply is infinitely elastic).[2][3] When governments
intentionally do this, they devalue existing stockpiles of fixed income cash flows of anyone
who is holding assets based in that currency. This does not reduce the value of floating or
hard assets, and has an uncertain (and potentially beneficial) impact on some equities. It
benefits debtors at the expense of creditors and will result in an increase in the nominal price
of real estate. This wealth transfer is clearly not a Pareto improvement but can act as a
stimulus to economic growth and employment in an economy overburdened by private debt.
[citation needed]
It is in essence a "tax" and a simultaneous redistribution to debtors as the overall
value of creditors' fixed income assets drop (and as the debt burden to debtors
correspondingly decreases). If the beneficiaries of this transfer are more likely to spend their
gains (due to lower income and asset levels) this can stimulate demand and increase
liquidity. It also decreases the value of the currency - potentially stimulating exports and
decreasing imports - improving the balance of trade. Foreign owners of local currency and
debt also lose money, Fixed income creditors experience decreased wealth due to a loss in
spending power. This is known as "inflation tax" (or "inflationary debt relief"). Conversely, tight
monetary policy which favors creditors over debtors even at the expense of reduced
economic growth can also be considered a wealth transfer to holders of fixed assets from
people with debt or with mostly human capital to trade (a "deflation tax").
A deficit can be the source of sustained inflation only if it is persistent rather than temporary,
and if the government finances it by creating money (through monetizing the debt), rather
than leaving bonds in the hands of the public.[4]
Overall, our database indicates that about 53% of defaults include local currency bonds.
Over a longer time period, spanning the years 1800-2009, Reinhart and Rogoff (2009)
identify 250 cases of sovereign defaults on foreign debt against 68 cases of sovereign
defaults on domestic debt (i.e., 21% of total defaults), which are almost exclusively
denominated in local currency. This comparison suggests a recent dramatic rise of
defaults on debt issued in domestic currency.
The results show that the explanation of sovereign defaults significantly differs according to
the currency in which the debt is denominated. Column 1 of Table 6 indicates that the
probability to be in default on local currency debt is high when i) the level of foreign
direct investment coming into the country is low; ii) domestic investment is high and,
and iii) when the local currency is relatively overvalued. These variables help explain
sovereign defaults on local currency debt but have no effect on foreign currency debt.
The default probability on both types of debt raises with the level of inflation. However, the
effect is greater for local currency debt, thus highlighting a limited possibility to further
increase inflation through debt monetization.
We now discuss several dimensions that deserve a more detailed analysis. First, a
particularly interesting factor is the level of domestic bank lending to the private sector.
Because domestic banks are the major creditors of the government, they may be prevented
from providing liquidity and credit to firms in the case of sovereign default on local currency
debt (Acharya, Drechsler, and Schnabl, 2013). Hence, when the importance of bank lending
is low, the costs of default on domestic debt in terms of a contraction in credit become less
severe and the default option is expected to be more favorable for the government (see
Gennaioli, Martin, and Rossi, 2013). In line with this intuition, countries with a low level of
domestic bank lending (i.e., low default costs) are more prone to sovereign default. However,
this relation should only be relevant for the analysis of local currency debt, as foreign
creditors dominantly hold foreign currency bonds.
We rst show that, when the government lacks credibility, the ability to generate seigniorage
revenue and debase debt with ination (two key attributes of monetary sovereignty often
emphasized in the debate) cannot prevent selffullling debt crises. The reason is
straightforward: ination is not costless. There are trade-os between default, taxation and
ination that bound the degree to which the central bank is willing to ex-post inate public
debt away in response to nancial distress. Moreover, the moment investors anticipate
inationary nancing, interest rates would rise, reducing the gains from debt monetization
up to the point of undermining its eectiveness altogether.
We start with the analysis of how the government choose the level of taxation and default in
period 2 under discretion, i.e. taking the interest rate set by the market in the previous period
as given. The policy trade-os faced in this choice are of course rooted in the economic
distortions implied by dierent policy options, i.e., defaulting versus running large primary
surplus. In the spirit of Calvo, we proceed by specifying the relevant distortions in reduced
form, referring to the relevant literature which has provided micro-foundations to them.
For example, we find that government default reduces the value of bank reserves (a direct
effect) which can disrupt the intermediation process thereby producing important indirect
effects including: (a) stunting capital markets resulting in lower firm output, and (b) reducing
the money supply via heterogeneous firm loan defaults. Unexpected monetization can also
have damaging consequences insofar as the resulting unexpected inflation (a direct effect)
can have important indirect effects including: (a) changing asset prices and money velocity
as payments work their way through firm and bank income statements thereby reducing
the share of output going to savers by even more than the amount consumed by
government, and (b) causing banks to become insolvent and fail as banks mark-to-market
their bond portfolios which decline in value as interest rates rise.
In other words, while monetization has the potential to collapse banks and reduce
output, it does not always do so; sometimes monetization simply raises prices without
destabilizing banks and is thus sometimes less damaging than default. Money printing
always reduces the price of bonds and imposes an inflation tax on depositors, either because
the money supply rises (as occurs when output is not disrupted) and/or because aggregate
output falls (thus leaving fewer goods for the dollars to chase), and this inflation tax shifts
resources away from households and towards government. If bank profits are increased,
thus increasing velocity, household consumption will fall by even more than government
consumption increases.
What is less clear is why a poorer developing country or emerging market, that has a
relatively underdeveloped financial sector, and hence little direct costs of default, would be
willing to service its debt. Of course, one could appeal to reputation models where
governments strive to maintain the long-term reputation of their country even though default
is tempting. However, we are more realistic (or perhaps cynical). Most governments care
only about the short run, with horizons limited by elections or other forms of political mortality
such short termism is perhaps most famously epitomized by Louis XV when he proclaimed
Apres moi, le deluge! (After me, the flood.) Shorthorizon governments are unlikely to see
any merit in holding off default until their country becomes rich, solely because their
reputation then will be higher after all, the benefits of that reputation will be reaped only by
future governments.
We examine the question of why a government would default on debt denominated in its own
currency. Using a newly constructed dataset of 14 emerging markets, we document that the.