Beyond Debt Transparency: Better Borrowing with Bond Oversight

For the first time in a long time, investment experts are predicting that credit markets will perform better than corporate stocks. If you are a government looking to borrow or a lender/investor, what can you do to make sure that you understand risk and that there is adequate oversight?

Credit: Alice Pasqual via Unsplash

By Joseph Foti

For decades now, stocks have returned double-digit gains. But experts increasingly think that that time is over at least for the short term. In a rare instance, investment balances are shifting to high-quality bonds. With expectations of continued economic growth, sovereign bonds — or borrowing by national governments — are climbing in value. This is happening in Canada, the Eurozone, the United States, and most emerging markets, with the notable exception of China.

The story is very different for a number of other countries. Some are in a difficult position due to debt crises and restructuring. Others are on high alert, carrying out “debt-management operations” to bring their debt repayments down in order to spend their money on other things.

We know that taking on debt is necessary for growth. But some debt is better than others. A growing body of research shows that managing this debt in a transparent and accountable manner gives a country (or locality) clear governance benefits. Better governance leads to a higher bond rating, which means cheaper borrowing. As a consequence, less public money goes to paying interest and can instead be used for capital investment.

In this explainer, OGP Horizons takes a dive into the world of publicly traded credit markets and how open government approaches can ensure better returns for investors and cheaper money for borrowers.

Bonds and Borrowing for Beginners

Most people are familiar with stocks. A stock is a share in a company. When someone holds a stock, they have a claim on the company’s profits and losses. It can be sold for more money when people expect the company to make more profit and less when they expect it to make less. Companies may pay out “dividends” to holders in the form of quarterly or annual payments.

Bonds, by contrast, are borrowing. But unlike other borrowing methods, bonds are traded in public markets. This is how the process of creating and buying bonds works:

• Lenders: A company or government takes out a loan from a lender. Often these lenders are investment banks or brokers that bring together multiple investors.
• Interest rates: Whoever holds those bonds is paid interest (a “coupon rate”) at fixed intervals across a year. (Rarer “zero-coupon bonds” get paid at the end of a fixed period such as two, five, or ten years.) If the original lender thinks that the borrower is less likely to pay back a bond, they charge a higher interest rate.
• Ratings: Once a bond is issued, it gets a “bond rating” from independent, third-party ratings agencies like Standard & Poor’s Global Ratings, Moody’s, and Fitch Ratings. A higher rating means lower default risk and lower interest charge. Borrowers with AAA ratings can usually borrow at the lowest rates.
• Trading: Then, individuals or firms may buy shares of those loans from the original lender in the form of “bonds.” People pay more or less for bonds based on whether they believe the borrower can pay it back. A drop in bond value means investors demand a higher return to compensate for perceived risk or changing market conditions (such as higher interest rates). This can lead to higher borrowing costs for the original issuer, as they may need to offer new bonds with higher interest rates to attract buyers.

Roots of a Crisis

There is a burgeoning sovereign debt crisis in large parts of the world. Five countries have recently defaulted on their debt or are on the edge of default (Chad, Ethiopia, Ghana, Sri Lanka, and Zambia), while as many as 50 may be in crisis. How did we get here?

Borrowing is essential for economic growth. But unchecked borrowing poses serious risks to both national governments and their citizens. While countries like Zambia and Sri Lanka made headlines when they defaulted on their sovereign — or national — debt, they are not alone. Local governments and state-owned enterprises (SOEs) are also vulnerable to unsustainable debt, poor choices, shocks, or mismanagement. Private sector borrowing can create systemic financial risks as well, especially in countries where banks hold significant amounts of sovereign or corporate debt. In Greece, Ireland, Argentina, Japan, and Iceland, where industries were “too big to fail,” the governments nationalized private sector debt and then had to restructure the loans to be able to pay back the debt.

Unsustainable debt has direct consequences. Many African countries are borrowing at high rates. This is a problem as economic growth might not be sufficient to pay down these debts in the future. Countries like Kenya have seen lenders demand rates as high as 18 percent. This reflects the assumption by lenders that those countries will not be able to pay back their loans by the end of the loan term, so they charge higher interest rates to make sure that they recover their costs early. This is bad for the countries because they must divert public funds to pay exorbitant interest, which takes money away from infrastructure, security, or social spending — the very things that would help them grow their economies.

In an average market, people rarely buy things they cannot afford and creditors generally do not lend them money to do so if they do not think it will be paid back. But sovereign bond markets are subject to particular risks. These fall into two categories–monetary risks and governance risks.

When governments borrow, especially if they borrow in dollars, there are three issues to keep in mind:

• Exchange rate: When countries borrow in foreign currencies, like the US dollar, their ability to repay fluctuates with their local currency’s value. A steep devaluation can lead to an unmanageable debt burden. US dollar strength may make it harder for emerging markets to pay back their debts.
• Interest rate/local monetary controls: Local monetary policy expectations shape investor sentiment. Countries with unclear or volatile monetary frameworks face higher premiums as lenders hedge against the unknown.
• Credit: Local economies can be subject to internal shocks (economic or social instability, or natural disasters), external shocks (such as the high cost of input like oil), and weak institutions (such as central banks with weak independence).

Transparency matters — investors charge more when they lack trust in or data about the borrower. High rates disproportionately cost more for countries with weak transparency and accountability frameworks, even when their economies show signs of resilience. Why, then, do countries take on this kind of debt? And why would lenders lend to them?

1. Moral hazard: Many governments assume that international lenders or institutions like the IMF will provide bailouts if things go awry. This belief can incentivize over-borrowing or risky spending. Politicians may also choose to follow the rosiest projections on their returns on investing in ports or developing oil fields. By the time those projections do not pan out, they are out of office.
2. Kickbacks and corruption: In some cases, politicians and officials prioritize deals that benefit them personally through bribes or kickbacks.
3. High returns for lenders: Private lenders profit significantly from high interest rates, collecting substantial returns upfront and cushioning themselves against future defaults.
4. Stock flow adjustments: This is a fancy name for when “hidden debt” is revealed. Lenders may simply not know that debt exists, or may have priced in their uncertainty about how much debt a country has.

Governance risks are not just market problems. When markets fail, there are also governance problems. These problems exist when there is lax oversight or there is inadequate transparency. In essence, while behavior may change over the course of decades, individual politicians — often responding to public pressure–“overborrow.”

For a much better explanation of these concepts, see Ken Opalo’s ideas here.

Beyond Transparency: New Opportunities for Public Oversight

Transparency and good governance in government borrowing decrease uncertainty, which allow governments to borrow for less. They get more capital and pay less interest. OGP has a number of guidance pieces on how to make debt more transparent, much of it led by the National Democratic Institute.

But is transparency enough? Markets, in many cases, are not encouraging more responsible borrowing, nor are individual banks. Here are three ”next generation” interventions that might help:

1. Oversight committees within bond agreements: Most bonds, especially those issued after a default, have an oversight committee. These are made up of stakeholders such as lenders, government officials, legal advisors, and financial experts. Some local governments include independent citizens or representatives of local watchdog organizations. In the western United States, many individual bonds have citizen oversight membership on their committees, although the practice is inconsistent and not standardized. A number of public utilities (special multi-jurisdiction governments like transit authorities, school districts, or water systems) also have citizens on their committees. These committees ensure that funds go to their intended projects, comply with ethics rules, and follow the law, including any potential rules on competitive collusion. Of course, there may be instances where too many oversight requirements might weigh down a process that has other safeguards.
2. Strengthening parliamentary oversight: National and local legislatures can strengthen their role in debt governance. They can ask for detailed reporting on new bond agreements, including comprehensive assessments of long-term risks. This helps ensure borrowed funds go to public priorities.
3. Better pricing through better measures: Research shows that good governance increases the likelihood of successful repayment. Reduced risk leads to cheaper money and better use of borrowed money. Yet ratings agencies do not always have the most accurate data on the policies that matter most. At the same time, governments may not always be able to pinpoint which policies need improvement to reduce default risk and increase spending impact. Broad indicators such as the World Governance Indicators or the Varieties of Democracy indicators may be mathematically predictive of performance, but they are not necessarily actionable in terms of policy change. Governments, ratings agencies, and oversight committees would benefit from policy-specific binary indicators. Clear, actionable metrics can improve country assessments and lead to fairer borrowing costs for countries with strong governance practices but poor reputations in global markets.

When governments embrace open governance practices and leverage these innovative tools, the benefits extend far beyond lowering interest rates. They enhance trust between citizens and institutions, unlock new opportunities for investment, and pave the way for sustainable economic growth.