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26 April 2012, Gateway House

How secure is sovereign debt?

This article attempts to explain the current crisis facing the world, and in particular many European countries, relating to sovereign debt and the consequent crisis, in simple layman’s terms. It also suggests how best India can weather this crisis.

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Families have to live within their means. Companies, too, have to live within their means, i.e. their expenses have to be restricted to their revenue. In the short term individuals do borrow money, as do companies, but it is at a cost (interest) and both principal and interest have to be repaid in the course of time. Likewise, Governments, too, need to live within their means i.e. expenses of the Governments should ideally be limited to taxes and any other income that may accrue to them. Unfortunately, Governments run deficits. For instance, France has had a deficit every year since 1974.

Just as individuals and corporations borrow money, the Government too can, and does, borrow money, from its own citizens, banks and sometimes from overseas entities, though ideally this should be a short term measure.  Government borrowings referred to as Sovereign or National debt, too, have to be repaid. Such debt is principally the accumulation of past fiscal deficits.  Since the borrower is the Government itself, the assumption is that the debt is money lent to the Government is absolutely safe and secure and the Government cannot default and therefore, the interest on such debt is always very low.

However, every Sovereign Government has another option, not available to individuals and corporations. It can print notes called deficit financing and discharge its debt. This has the economic implication of increasing the money supply in circulation. Any elementary text book in economics will tell you that this results in inflation, which is the worst form of taxation, because it taxes both the rich and the poor alike, by the same percentage amount. The cash in circulation in India has tripled in the last 3 years. Witness the consequent reaction against inflation in India.

Governments succumb to the temptation of spending more than they earn, sometimes, for legitimate reasons. Some politicians believe that they will be in power only for their tenure of office and hence the responsibility of repaying any debt will shift to the next Government and they can therefore, wash their hands off this duty and obligation.

Excessive Government borrowing has today become a worldwide scourge. Governments of both rich and poor countries borrow money.  On an average, across the world, Governments have borrowed about 80% of their GDP. Economists postulate that borrowing beyond 100% of GDP can lead to a debt trap. Constitutional experts and economists now advocate a constitutional ceiling on National Debt. In September 2011, Spain amended its constitution to force the Government to balance its budget and imposed a ceiling of 40% of GDP on its National Debt during peace time. Surprisingly, Government borrowing, in terms of percentage of GDP, in Japan, is the highest in the world viz. 2.2 times it’s annual GDP. An OECD report predicts that this may rise to 2.3 times the GDP. Fortunately this borrowing is from its own citizens and banks. Interestingly enough, Japan is simultaneously the world’s largest creditor nation with net foreign assets totaling $3,300 billion. Repayment of a large National debt may often be impossible. IMF has in fact warned Japan that it can face a Sovereign Debt crisis. The Prime Minister of Japan, himself, has warned the country that a crisis may be looming. The US has historically been more conservative. Under the Clinton Administration, the federal budget had a surplus of $122 billion in 1999 and $230 billion in 2000. The US Government had to borrow money due to its expenses on the Vietnam, Afghanistan and Iraq wars. This was further aggravated due to the federal bail out following the melt down in 2008. America’s national debt is now above $15 trillion i.e. over 90% of its GDP.  China, Japan and Brazil have invested $1300, $888, and $198 billion, respectively, in U.S. Treasury bonds. Fortunately, for the USA, many institutions including Citibank are repaying their bailout and their auto industry has recovered.

The Sovereign Debt of some countries, and in particular of some European countries facing a crisis, is given below: (2010)

Sr. no. Country % of GDP (IMF)
1. Japan 220
2. Greece 143
3. New Zealand 132
4. Italy 119
5. Ireland 95
6. Portugal 93
7. Iceland 92
8. Spain 60

Four of the above countries viz. Portugal, Italy, Greece and Spain are loosely referred to as PIGS. It is not a coincidence that these countries are in a crisis since they cannot repay their debts. Besides the PIGS, many other countries have announced severe budget cuts, to reduce their fiscal deficits.

As a consequence the Euro Zone, which started with 11 member countries, and now constitutes 17 member countries, is in a crisis; since the currency of all the countries is common viz. the Euro, countries having Euro as their currency do not have the option to print their own Bank notes. This can be printed only by a central agency viz. the European Central Bank or ECB. Presently, this option is being explored. Some preliminary agreement has been reached about a bail out for Greece, but the amount falls well short of the country’s needs.

The next in line is Italy.  Italy’s Sovereign Debt is the largest in Europe i.e. about $2500 billion and its GDP is $2,050 billion. Other nations may follow suit. It is estimated that countries in the Euro Zone need $3,000 billion as bail out funding. The Euro Zone has formed a $1,000 billion rescue fund called the European Financial Stability Facility (EFSF), backed in part by guarantees from its member nations, but this falls far short of the need of $3,000 billion.  The best economists in the world are grappling over this problem. There is obviously no simple solution. The option of default is always there, i.e. nations can defer payment or repay only a partial amount. This will naturally lead to a crisis of confidence. In fact, Greece has already suggested a “haircut” of 50% i.e. a write-off of 50% of their debt to lenders.

Germany has shot down a proposal for borrowing, using a Central Euro bond. Chancellor, Angela Merkel has publicly stated that “this is Europe’s darkest hour since the Second World War” and argues that if the Euro zone has to survive then its members will have to cede some of their economic sovereignty. In other words, they should consider forming a USE i.e. United States of Europe.

A fallout of this crisis is the slowing down of investments and growth. This has resulted in unemployment, due to lack of confidence by employers. Spain currently has 25% unemployment. If only youth are considered unemployment is almost 45%. In Britain too, youth unemployment is 22%.

What is interesting is that even rich nations
that include USA, Singapore, Germany, Canada, France, UK and others are some of the worst culprits, when it comes to sovereign debt.

Paradoxically enough, poorer nations, particularly those in Asia, seem to have a much lower national debt as given below:  ( 2010 )

Sr. no. Country % of GDP (IMF)
1. Indonesia 27
2. China 34
3. Nepal 36
4. Pakistan 57
5. India 64

** Presently over 80%

Of course, the oil rich countries also have low National Debt. These include:

Sr. no. Country % of GDP (IMF)
1. Iran 12
2. Kuwait 10
3. Nigeria 17
4. Oman 6
5. Qatar 27
6. Saudi Arabia 10

Rectification of the shortfall between income and expenses by the Government is fraught with its own political implications. Witness that the Governments of Greece, Italy, Ireland and Spain have fallen. Also witness the fact that workers in UK went on strike, because the Government wants to rectify the anomaly in their retiral benefits.

There is a concerted international effort to save the Euro Zone. However, if this fails then the options can spell even greater disaster. The weaker nations such as Greece can leave the Euro Zone. Alternatively the stronger nations such as Germany can exit.

The current worldwide economic crisis started with the meltdown in the USA in 2008. It has now spread to the Euro Zone, where many countries are unable to re-pay their national debt. Asia too has been affected thanks to Japan’s earthquakes and Tsunami, besides its massive national debt. New Zealand, with a National Debt of 132% of GDP is similarly facing a crisis.

The GDP of the Euro Zone is about $13 trillion i.e. around 20% of world GDP. A crisis in this Zone will naturally affect all of us. Despite severe budgetary cuts, Greece estimates that its National debt will reduce from 143% to 120% of GDP only after 10 years. Similarly, Italy states that its National debt will reduce from 120% to 100% only after 20 years.

Another serious problem is the under-capitalization of banks in Europe.  Some estimate capital deficiency at over $150 billion. Even SBI, in India is under-capitalized, which is why its rating was downgraded by S&P in October 2011. As we know, S&P had earlier downgraded US Treasury bond rating from AAA to AA on Aug 5, 2011.

Correction of economic disorder is best left to professionals. I feel proud that my alma mater MIT is making a significant contribution. Mr. Draghi, President of the European Central Bank is an MIT Alumnus. Ben Bernanke, the USA Federal Reserve Chairman, Olivier Blanchard, IMF’s Chief Economist and Paul Krugman, New York Times columnist are all MIT Alumni. MIT has of course produced 4 Nobel laureates in Economics: Paul Samuelson, Franco Modigliani, Robert Solow and Robert Merton. In India too, in 1991 Dr. Manmohan Singh, a Cambridge and Oxford educated economist, and presently our Prime Minister, played a stellar role in extricating India from an economic crisis. India, then, had to pledge gold as collateral to the IMF to borrow $2.2 billion. It also had to physically ship 67 tons of gold, as security, to borrow $600 million from the Bank of England and the Union Bank of Switzerland. Interestingly the new Government of Italy headed by Mario Monti, does not have a single politician in the cabinet. It constitutes only academics, technocrafts, bankers and ambassadors.

In view of the above global economic service, we need to answer 2 important questions:

  1. How secure is Sovereign Debt and will interest rates on government bonds go up?
  2. What should India do to weather this storm?

Sovereign Debt is now no longer 100% secure. Hence, interest rates on Government bonds will go up. In fact, the interest rates of Italy’s government bonds have lately exceeded 7%. This will further widen the fiscal deficit, forcing both increased taxes and reduction in government expenditure. Both have apolitical fallout as nobody likes increased taxation, and reduced government budgets impact infrastructure development, government employees, defense, and subsidies to the weaker sectors.  The good news is that virtually no one in India is apprehensive of a default in National Debt.

India has been hitherto sheltered. Both the Government and the RBI need to be complimented. Earlier, we had weathered the Asia financial crisis of late 1997. We also withstood the 2008 meltdown in the US. Despite the EU crisis, our GDP growth this year, too, will be around 7%.

However, this time we do not have just gusty winds, we have a storm. The US, Europe and even some countries in Asia have caught a cold. When the entire world catches a cold, India cannot be an exception. We will catch a cold. Question is, can we lessen its impact?

We live in an interconnected and interdependent world. We cannot wish away our dependence on other countries. On an average, over 1/3 of the products manufactured in any country are consumed in other countries. The developed world is faced with a very serious problem with which it is grappling, with no simple solution in sight.

For instance, if unemployment in the USA is about 10%, Spain 25% and UK 8%, surely outsourcing will get adversely impacted. Further, next year the US has its Presidential elections and it is easy to predict the rhetoric against outsourcing to China and India.

India needs to take several immediate measures to withstand the present and future storms. Some of them are :

  1. Correct the sectoral imbalance in our GDP: Today the ratio of manufacturing, agriculture and services in our GDP is 26%, 19% and 55%, respectively. The share of manufacturing in China’s GDP is 47%, Malaysia 42%, Thailand 45% and Germany 28%. Economies transition from agriculture to manufacturing to services is common. For instance the ratio in the US’s GDP is currently 22.2%, 1.2% and 76.6%, respectively. India is trying to leap frog from ag
    riculture to services. This may be a mistake. For instance, India makes only 70 million tons of steel p.a. vs. China’s 700 million tons. India produced 3.5 million cars and commercial vehicles in 2010 vs. 18.3 million in China. We can soon become dependent on the import of products.
  2. Encourage exports: We have to correct our trade imbalance. The gap between exports and imports is steadily widening.  RBI expects that in FY 11-12 our exports will be $300 billion and imports will be $450 billion, leading to a trade imbalance of about $150 billion. It has also estimated that this imbalance can become $450 billion as early as in 2014. India also has earned about $58 billion p.a. as remittances from its 22 million overseas Indians, largely in the Gulf, which is likely to decline fairly rapidly. The introduction of MAT, which is nothing but another word for income tax in EPZs, was a serious mistake, especially after the Government had made a solemn assurance of a 10 year tax holiday, on the basis of which considerable investments were made in many enterprises in such zones. This was a retrograde step. SEZs can help correct our trade imbalances and need to be strongly encouraged.
  3. Encourage Foreign Investments: We need to encourage overseas investments in plant and machinery.  India has one of the highest interest rates in the world which will encourage such inflows. Make the receipt of dividends into India, tax free, as in Singapore. Foreign Exchange inflows will increase the demand for the Rupee, making it stronger. Our present Foreign Exchange reserves of around $300 billion largely constitute hot money, since about $250 billion is from FIIs that can evaporate quickly.
  4. Curb Corruption:  Corruption and illegal money stashed overseas are a plague. Bimal Jalan, former RBI Governor, in his book, has estimated that corruption has resulted in a reduction of 2% in our growth rate. There is no precise estimate of illegal Indian money in overseas bank accounts, but this is estimated to be over US$1 trillion.  Decisive Government action can convert this money into an asset. If it can be brought into India in the form of plant and machinery, it can boost our economic growth. On the other hand, if it is brought back as cash it can fuel inflation.
  5. Curb inflation: Inflation is the worst form of taxation. The Government has led us to believe that economic development always comes at the cost of inflation. This is not true. In fact, Japan is currently experiencing deflation. Most of our inflation is caused by an increase in our money supply without a proportionate increase in the goods and services produced in the economy.  The Government must take steps to curb inflation.
  6. Reduce controls:  India still suffers from the British hangover of Government control.  This retards growth and encourages corruption.  The Government must transition from direct control to promotion and regulation.
  7. Restrict National Debt ideally by a constitutional amendment to a maximum of 100% of GDP, if not lower.
  8. Encourage Business:  Businessmen create enterprises and generate employment.  The economy runs on this.  There should be concerted efforts to encourage businessmen and particularly SMEs.  Interestingly enough in the US, the net increase in employment due to big businesses has been virtually zero in the last 50 years and it is the SME sector which has generated the entire increase in employment. Our policies and taxes should be pro-outsourcing by large business enterprises to the SME sector.  Japan has done this particularly well.
  9. Sell Government investments in non-strategic and non-performing sectors.  Over 90 i.e. ⅓ of Central Public Sector undertakings make losses. This will generate revenues for the Government and simultaneously improve performance of these enterprises. It can even increase net employment. Indian businessmen are good entrepreneurs.  Witness the change of fortune in Corus, Jaguar and Novelis.
  10. The Government must take pragmatic steps such as reduce subsidies and wasteful expenditure, tax rich farmers, change labor laws (I believe this will increase employment) and promote vocational training in education.
  11. Limit India’s National Debt as a percentage of our GDP, a suggestion recently made by the RBI, Governor.

Our National Debt is presently about 80% of our GDP and relatively under control. However, subsidies can quickly alter this situation. We need to ensure that we do not get into a debt trap like Greece, Italy, Spain, Japan and New Zealand.

India has a bright future if the Government thinks pragmatically. Demographics are on our side. India has one of the youngest populations in the world. Hopefully, an astute Government and the RBI will steer a course that will ensure that our GDP continues to grow at 8% + p.a., while simultaneously reigning in Sovereign Debt.

Dr. Lalit S. Kanodia is the President of the Indo American Chamber of Commerce and is a Member on various committees and councils. He is an international consultant and authors serious articles on the issues of economic development, particularly relating to that of India.

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