Perplexing Sovereign Debt to GDP Ratio:

between 237% Japan (April, 2017) and 59% Argentina (2018), which is more risky?

‘Gross Sovereign Debt to GDP ratio (Gross SD/GDP Ratio)’ is a measure to compare the level of sovereign government debts among different peers. In this measure, Japan has the world top position of 237% as of April 2017 (Chart 2); and Argentina has 56% in 2018 (Chart 1). Apparently, Japan is far more deeply indebted than Argentina. On the other hand, the credit ratings of their sovereign bonds cast a totally different story. While Japan’s government bonds (JGB) possesses an investment grade rating — rated A1 by Moody’s (December, 2014), A+ by S&P (April, 2018), and A by Fitch (April, 2017) — Argentina’s government bond (AGB) has a speculative/non-investment grade rating — rated B2 by Moody’s (November, 2018), B+ by S&P (August, 2018), and B by Fitch (May, 2018).

Are you perplexed?

If not, here are two very natural questions:

  1. Why are we facing a counter-intuitive credit rating between Japan and Argentina, given the relative levels of ‘Gross SD/GDP ratio’ between these two peers? Why does Argentina, given its lower debt level, have a worse credit rating than Japan? The more heavily indebted peer, Japan, has a better rating than Argentina. In a way, the more you borrow, the better credit rating you get! Why is that?
  2. Can Japan pay back the sovereign debt, given at the world top record level of 236% of its GDP (April, 2017)? In other words, is Japan OK?

Simply put, this counter-intuitive relationship between ‘Gross SD/GDP Ratio (Sovereign Debt to GDP Ratio)’ and ‘credit rating’ is shaped primarily, if not only, by the difference in the denomination of sovereign debts between these two countries. On one hand, JGB (Japan’s Government Bonds) are denominated in its own local currency, JPY (Japanese Yen). On the other, a significant portion of AGB (Argentine government bonds) are denominated in foreign currencies, predominantly in USD (Chart 3). This difference leads to a contrasting and critical difference at the time of the maturity of existing debts (the repayment of existing debts to their creditors). This content focuses on this primary driver, the denomination of sovereign debts, that divides the implications of ‘Gross SD/GDP Ratio’ in sovereign’s solvency risk (credit rating) between these two countries.

Here, in order to put them into a perspective of insolvency risk, let’s contemplate a crisis situation under the following two assumptions:

  • Assumption 1) both parties are in fiscal deficit and have to refinance in order to repay their existing debts;
  • Assumption 2) there is no willing-investors to purchase their newly issued debts.

Under this hopeless situation, what can they do?

As of today — whether it works forever is a different question to be discussed later — for Japan, it is a matter of issuing its own currency to service its outstanding sovereign debt, simply because its debts are denominated in its own currency. This is called ‘monetisation’ of sovereign debt. The monetised portion of its debt does not necessarily need to be repaid (to be explained). Thus, it is not a compulsory liability in a strict sense. In this sense, Japan appears to have no insolvency risk. Is that so simple? Can Japan increase its debt indefinitely through monetisation? This would be discussed later.

On the other, given the same conditions, Argentina, in order to pay back the foreign denominated portion of its sovereign debt, needs to get the foreign currency denominating its debt. Thus, for the case of Argentina, the sovereign debt management would involve currency risk: solvency risk and currency risk become the two sides of the same coin in Argentine sovereign debt management. For the case of Japan, currency risk has no direct involvement in the repayment process of sovereign debt. This difference in the denomination of sovereign debt can result in a critical difference in solvency dynamics.

Despite the fact that this difference is not the only factor that differentiates these two countries, it is a fundamental difference in the architecture of their sovereign debt management. Keeping this notion in mind, let’s compare the economic dynamics of these two countries’ sovereign debt management, one by one. Now, we start with Argentina.


Argentina

Now, how about Argentina? Repeatedly, our question is: while Argentine government’s ‘Gross SD/GDP Ratio’ is around 59% (Chart 1), well below the case of Japan, why is Argentine credit rating lower than Japan’s rating?

As stated earlier, a significant portion, around 70 %, of AGB (Argentine’s government bonds) is denominated in foreign currencies (Chart 3), predominantly in USD. That exposes Argentine sovereign debt management directly to currency exchange risk. That imposes on Argentina extra constraints that Japan does not face. Although there might be multiple ways to slice the constraining dynamics, let me portray the dynamics in the ‘Strained Triangle’ illustrated in Figure 1: the presence of foreign-currency denominated sovereign debts constrains three objectives: sovereign debt management; full sovereign discretion in fiscal policy; and full sovereign discretion in monetary policy. (Caution: This is different from the famous ‘Mundell-Fleming Impossible Trinity.’)

The two sides of the same coin: currency risk and foreign-denominated debt management

Repeatedly, the currency exchange risk is directly embedded in ‘foreign currency denominated sovereign debt management’ for Argentine case. And the risk materialises when the local currency depreciates. For the moment, before observing the interaction among three vertices of the Strained Triangle, let’s focus on the top of the triangle — foreign currency denominated sovereign debt management — to see how currency depreciation constrains the sovereign debt management in the local currency term:

  1. Retrospective transaction(s):
  • Due to currency depreciation, the repayment value would exceed the borrowed money in the local currency term. In other words, Argentina has to pay more than it borrowed. (Negative)
  • Due to the depreciation of the currency, the value of its outstanding USD-denominated debt will increase in local currency term. A heavier burden going forward. (Positive)

2. Current transaction: At the time of repayment, the Argentine government has to either use its currency reserve or obtain USD from the market.

  • As its currency reserve declines, there would likely be a speculative attack on ARP.
  • If the government has to acquire USD from the market, it needs to issue its local currency first then exchange it to USD. The transaction itself will impose a further downward pressure on its own currency and increase inflationary pressure on the domestic economy.

In either case, the repayment would be negative for the exchange rate. (Negative)

Obviously, these dynamics arising from foreign-currency denominated debt affect its own local currency denominated sovereign debt management as well. Thus, for Argentina, its sovereign debt management and currency management are two sides of the same coin. And the repayment transaction would be negative for the currency exchange rate, holding other conditions constant.

Now, let’s move to the interaction among the three vertices of the triangle.

Sovereign Discretion of Fiscal Policy:

How about the sovereign discretion on fiscal policy? ‘The assumption 1’ above supposes that Argentina has fiscal deficit: in other words, Argentina maintains its own sovereign discretion to expand fiscal spending. It would raise concerns among the debtholders, especially investors of foreign currency denominated AGB, and could trigger a negative chain reaction:

  1. First, it could induce the debtholders to sell their holding collectively: risk spread widening (negative);
  2. then, such a move is likely to induce speculative moves on the currency. (negative);
  3. in addition, it would compel locals to exchange their peso saving into USD via black markets for the sake of wealth preservation. (negative)

Overall, it would result in the depreciation of Argentinean Peso (ARP). The depreciation of ARP is unfavourable to the sovereign debt management for Argentina, as stated earlier. In the context of foreign-currency denominated sovereign debt management, Argentine government cannot have a full sovereign discretion over its fiscal policy: it might be compelled to impose an austerity to sacrifice basic subsidies that is a life line for a low-income class under the poverty line. Or, if Argentine government maintains its full sovereign discretion in expanding fiscal spending, it would compromise its foreign-currency denominated sovereign debt management. Thus, these two objectives cannot be met simultaneously. Argentina has to sacrifice either of the two objectives: credible sovereign debt management; sovereign discretion on fiscal policy.

Sovereign Discretion on Monetary Policy:

How about the sovereign discretion on monetary policy? It would depend on the effect of its USD denominated debt management on inflation rate. As stated earlier, at the maturity of existing foreign-currency denominated sovereign debt, the assumption 2 contemplates that there is no investor to purchase a newly issued bond. Thus, the government would have to monetise the refinance, which would increase the level of local-currency denominated sovereign debt. The repayment of its USD denominated debt by itself, requiring USD, is unfavourable to ARP, with other conditions constant. Its implication — the impairment in the purchasing power of the local currency — would induce local residents to sell ARP in exchange for USD. Furthermore, speculators would reinforce the momentum of currency depreciation. If the selling force goes beyond the level of its USD holding in the foreign currency reserve, the government would fail to stabilise the exchange rate. The resulting depreciation of the local currency must be positive for export, despite negative for import. But, is it?

  1. Importers:
  • Argentina is a capital goods importer. A higher price for capital goods import is negative for the domestic productions in both industrial and agricultural sectors. Uncompetitive domestic producers would not hesitate to increase their mark-up as well as to pass any increase in the cost to their customers.
  • In addition, in the absence of hedging instruments, Argentina suffers from increasing imported prices. (This differentiates Argentina from Japan, where currency depreciation would not necessarily influence domestic prices of export products partly because there are a variety of hedging instruments available to both export producers and importers.)
  • An acute depreciation in currency could make it difficult to pass the cost to customers. As a result, production can plunge. In addition, if at a high level of inflation, there would not be any credit available for leasing or financing. This will damage imported capital goods sales to export producers.

2. Exporters:

  • Exporters would sacrifice domestic supply in order to earn better currency abroad. Thus, domestic prices of export products tend to be influenced by international prices which is denominated in USD.
  • In the case of an acute currency depreciation, as stated earlier in the import section, the volume of Argentina export products will stagnate due to increases in the cost of finance due to the rising interest rate as well as the cost of capital goods for production. As an example, recent deterioration in ARP actually destroyed credit available for the agricultural producers and reduced the sales of agricultural capital goods by 35%. (Bertello, 2018) As a result, the rising interest rates and the increased cost of import stagnated the volume of export productions. Thus, Argentine export volume is expected to decline.

A simplistic adjustment mechanism — a cancelling-out trade-off between the changes in importers’ and exporters’ revenues due to a change in the exchange rate — would unlikely work for Argentina. Overall, currency depreciation could be ‘stagflationary’ — a synthetic term of ‘economic stagnation’ and ‘inflation’ — for Argentine domestic economy. If the government tightens monetary policy in the middle of fiscal deficit, the economy would further slowdown. In this stagflationary setting, its monetary policy and fiscal policy face a dilemma. In addition, it could lead to a selling of AGB and an increase in the yields of AGB, the cost of funding for sovereign finance. It also would be negative to the currency exchange rate.

Overall implication:

Overall, three objectives — credible sovereign debt management, sovereign discretion on fiscal policy, and sovereign discretion on monetary policy — are impossible to be satisfied at the same time.

Contagious Triangle:

The problem could go beyond the impossibility of meeting the three objectives together at the same time. When Argentina sacrifices or fails one objective to a significant extent, the negative effect would transmit into the management of the other two objectives. Thus, ‘Strained Triangle’ becomes ‘Contagious Triangle.’ (Figure 2)

If the country fails to manage inflation to a significant extent, it would lead to the depreciation of the local currency; which would impair the sovereign debt management. Also, the currency depreciation itself, as stated earlier, is inflationary. These two factors reinforce each other and create a vicious cycle. Overall, the resulting negative prospect would induce capital drain out of the country. And the shortage of capital would be negative for the economic growth, thus, call for fiscal expansion. It shapes a full vicious contagious circle.

If it fails to manage fiscal imbalance to a significant extent, it would directly breach a credible sovereign debt management, by increasing debt. This would raise concern among investors and lead to the depreciation of local currency, which would be inflationary as stated earlier. When speculators attack ARP, locals also sell ARP in exchange for USD in order to preserve their wealth. Simply put, a collapse in the public confidence in the local currency would exacerbate inflation. It becomes a matter of time for the government to make its political decision to reschedule its debt service. Should they default, it would cause a catastrophic depreciation/devaluation of ARP, thus, further exacerbate inflation and cause a economic and political panic.

When any of the objectives on the vertices of the triangle fails to a significant extent, it could trigger a negative contagious chain reaction in the triangle.

This contagious scenario is a key risk in the presence of foreign-debt denominated sovereign debt.

The following charts — currency exchange rate (Chart 4), current account (Chart 5) as well as net trade (Chart 6), and the level of its sovereign debt (Chart 1) — reveal that after 2013 (framed in red dotted boxes) Argentina has progressively suffered from ‘Strained Triangle.’

These four measures have been progressively deteriorating since the current president, Mauricio Macri, came into the office in December 2015.

Unfortunately, we do not have reliable inflation statistics of this country since the government manipulated the official release of the statistics in the past. (Economist, 2011: Economist, 2012) Instead of inflation rate, we have Argentine policy rate in Chart 7 below.

Since April 2018, the central bank started hiking again its policy rate in order to contain the rising inflation rate. The rising policy rate together with these deteriorating four measures above suggest that now Argentina entered into ‘Contagious Triangle’ in 2018.


Japan

How about Japan? Why can Japan maintain an investment grade rating even at 236% (April, 2017) of Gross Sovereign Debt per GDP Ratio? What’s different from Argentina? Is the denomination of their sovereign debt only the difference?

In hindsight, Japan has already begun its monetisation of sovereign debt quite aggressively. Chart 2 shows the evolution of monetisation since 2013. In 2016, Japan’s cumulative monetisation reached 33% of its total government debt, which is equivalent of 77% of its GDP. In other words, the government’s compulsory liability to other parties (excluding its central bank) is 160% (237% — 77%).

Monetisation, inflationary by its design:

Monetisation is inflationary by design. Let’s see the process of monetisation step by step.

  • Step 1) the government issues a new debt in order to pay back its existing debts;
  • Step 2) on behalf of the government, the central bank issues currency in order to buy the newly issued debt;
  • Step 3) once the government receives the proceeding it uses the currency to repay the debts to the creditors;
  • Step 4) the currency either circulates into the economy or is saved in bank deposits;

Simply put, a monetisation process makes the central bank the creditor for the monetised portion of the sovereign debt — needless to say, the government is the debtor. Since in a crisis time its theoretical ‘political independence’ might be breached or compromised, here if we treat the central bank as a part of the government in a loose term, the monetised portion of its debt would not need to be repaid ultimately, simply because the government cannot default on itself.

Japan has already demonstrated to the world that it could reduce the level of debt owed to other parties (excluding its central bank), call it ‘non-government liabilities,’ by increasing monetisation. In this sense, to non-government parties, Japan has no immediate solvency risk as of today. If there is no immediate solvency risk, non-government investors might not feel any immediate necessity to sell JGB collectively.

Inflationary Monetisation and its Long-term Implication

Is that so easy? Can Japan continue monetising its debt and reduce its debt effortlessly?

Here is an obvious risk that monetisation can cause. Monetisation by design only injects new currency into the system, but does not absorb the same amount of currency out of the system since the newly issued debt is not bought by any non-government buyer in its process. Therefore, its net effect is only inflationary. If the resulting inflation goes out of expectation and control, it would raise a concern since inflation impairs the purchasing power of money.

The recent Venezuela’s story that its annual inflation hits 488,865 percent in September reminds us that an extreme inflation can destroy the public confidence in its own currency and trigger a variety of economic and political catastrophes. (Ellsworth, 2018) It could suggest us that should inflation that Japan’s sovereign debt management accounts for go beyond its control it could destroy the public confidence in JPY. And it is manifested not only by inflation rates but also by the deterioration in currency exchange rate. This should remind us of the triangle we saw in the case of Argentina. For Japan’s case in the absence of foreign-denominated sovereign debt, the top vertex of the triangle in Figure 2 would simply represent the currency risk.

So far, Japan, just coming out of its deflation, there is no immediate concern on material inflation risk arising from the current monetisation activity. Thus, it might be hard to imagine what inflation implication monetisation can account for. Here, in order to put it in a perspective, let’s contemplate implications of an extreme inflationary situation.

  1. Uncontrollable inflation beyond the long term target level itself is an evil. (Negative)
  2. Inflation would reduce the real value of the legacy debt since it is denominated in the local currency: that would be positive from the perspective of solvency, as long as its legacy debts are concerned. (Positive)
  3. Inflation would increase the cost of funding toward the future. Future issuance of debt would become increasingly costly and difficult. (Negative)
  4. An acute decline in the purchasing power of money would make it difficult for Japan to issue its sovereign debt in its own currency to attract domestic investors as well as foreign investors; (Negative)
  5. Whether Japan can extend monetisation of debt, knowing that it has inflationary implication, would depend on the existing level of inflation. If inflation goes out of control, sooner or later a political decision might be made to default on or reschedule the outstanding government debt. (Negative)

The second item above suggests that inflation does present a favourable impact on Japan by reducing the real value of its debt. On the contrary, for the case of Argentina, inflation only present negative impacts on its debt due to the presence of foreign-currency denominated debts.

Nevertheless, the overall effect of an extreme inflation could ruin the public confidence in its local currency, thus, it would be negative for Japan’s entire economy. Also causing a spike in the future funding cost, an extreme inflation would be a real threat to Japan’s sovereign debt management. And there is no guarantee that Japan would not experience extreme inflation in the future.

Long-term Implication: Uncharted Risk on the Horizon

As a matter of fact, Chart 8 illustrates the historical level of monetary base (in the blue line) built-up as a by-product of quantitative easing (QE). And banks’ reserves at the central bank constitutes about 68% of monetary base in July 2018. Cut the long story short, the total banks’ reserve level sets the upper limit of the private sector’s lending activity in the economy. In other words, the current upper limit is set at a historically high level. So far, the private sector’s lending activity, measured by ‘M2/Monetary Base’ of the grey line of the chart, has declined dramatically since the bursting of its bubble in the 90s: that is why inflation as well as the economic growth has been low. Nevertheless, once the lending activity picks up, with the historically high upper limit of the private sector’s lending activity, inflation can go up to an unprecedented level. Of course, such an extreme scenario does not necessarily need to happen. No one knows for sure whether this risk would materialise or not. Especially, the history proves that QE does not work. (Suginoo, 2018) We do not know how our future economic conditions would unfold in relation to the level of monetary base. However, the level of monetary base in Chart 8 presents an uncharted risk in our unknown future on the horizon.

Deflation: Strategic implication of Deflation for Government Debt Monetisation:

How about deflation? How could deflation interact with monetisation?

  • Deflation would obviously increase the real value of its legacy debt. (Negative)
  • On the other hand, the cost of funding would be cheaper for a new debt. (Positive)
  • Monetisation would not have a material impact on inflation. (Positive)

In this sense, deflation is a favourable condition for monetisation. At least, as long as inflation is contained within an expected low range, monetisation would not cause a panic collapse of the public confidence in the local currency.

Thus, a strategic implication would be that Japan should accelerate its monetisation to reduce non-government liabilities as much as possible while inflation expectation remains low. In this way, Japan could reduce the compulsory portion of its government debt without causing a collapse of the public confidence in JPY.

In addition, to reduce inflation risk, it would be imperative for Japan to reduce monetary base as soon as possible. Monetary policy, primarily focusing on supply side of the private sector’s lending activity, has been proven ineffective in restoring Japan’s economic stagnation, which is caused by its impaired demand. Thus, it is fiscal policy, not monetary policy, which is necessary to stimulate the demand and restore Japan’s economy. So, Japan would need to reduce its ineffective as well as unnecessary monetary base drastically to a normalised level so that it can reduce the risk of future inflation and optimise its fiscal policy effect.

Other Implications:

Of course, the backdrop of monetisation is Japan’s chronic fiscal deficit which was the flip-side of its low unemployment rate. A chronic fiscal deficit can account for other negative implication: as an example, structural imbalances that would inhibit innovation from taking over the old legacy systems. Japan needs to assess the long term implication over its chronic fiscal deficit. Before too late, the government has to take a preventive measure to avoid the full collapse of the public confidence in the local currency. Sooner or later, the country would need to settle itself somewhere between a creative destruction for progress and full-employment via its chronic fiscal deficit.


Big Picture:

The denomination of sovereign debt, although it is not the only driver that divides economic dynamics between Japan and Argentina, is a fundamental difference in the construct of their sovereign debt management dynamics. Together with given distinct monetary conditions, foreign-currency denominated debt can deprive Argentina of its sovereignty over fiscal and monetary policies. In a way, Argentina, by issuing foreign-currency denominated sovereign debt, has abandoned its sovereign freedom to manage its fiscal and monetary policy.

While Japan has so far enjoyed ‘foreign-currency denominated debt’ free status and maintained its sovereign discretion over fiscal and monetary policies, there is no guarantee that its rating would remain an investment grade in the future. Should it ruin the public confidence in its own currency, it has to face future funding problem. Although there is certainly such risk present on the horizon, there is no prognosis of its materialisation yet. For the time being, its monetisation can conveniently eat up the non-government liability portion of its legacy debt.


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