The use of the term “sovereign risk” by Trade Minister Andrew Robb to describe the federal budget stalling in the senate shows just how fast and loosely the term has come to be used.
But to whom is the risk? Who would bear the cost of the downside? What caused the risk? How big is the risk in the context of the overall costs and benefits of the action?
Traditionally sovereign risk was the risk of less developed country governments defaulting on their foreign currency debt to banks or developed country governments. It could also be taken to include the risk of expropriation and nationalisation of private assets. More recently the term sovereign risk has come up in relation to the risk of default on euro debts held at the European Central Bank by EU members following the GFC.
Stretching it further, sovereign risk has been applied to the consequences for business profits of a change in taxes, subsidies or regulations. This is a narrow focus on the perceived costs to commercial interests of government actions, rather than the question of appropriate policy.
Sovereign risk origins
Removal of the restrictions on cross border currency flows in the late 1960s increased international bank lending to the less developed countries (LDCs).
Due to expanding LDC exports of oil and other resources to the rich countries especially the US, huge amounts of US dollar revenue (petrodollars) were deposited in European banks. LDCs were encouraged to borrow those funds in order to finance economic development. But many LDCs did not get the anticipated economic growth and increased exports that would generate more foreign currency and allow them to repay the mainly US dollar debt.
Foreign debt repayment difficulties resulted in moral hazard whereby higher interest rates increased the risk of default. Unable to repay or even service the foreign debt especially when interest rates rose, LDC governments were forced to refinance (recycling) and many were trapped in ever increasing foreign debt. To boot, often weak neo-colonial LDC state institutions encouraged corruption and capital flight, whereby foreign currency was siphoned out of the country by corrupt elites, Marcos in the Philippines among many.
Some LDCs came to owe more in yearly foreign debt service than their total exports or even GDP were worth. Domestic currency devaluation led to dearer imports for development and high inflation - Keynes’ famous “transfer problem”. Living standards and basic infrastructure and services (education and health) deteriorated in many countries despite continuing massive resource exports, especially for the poorest. While sovereign risk focused on commercial concerns including bank losses, many people in LDCs faced enormous costs in terms of poverty. The risk of nationalisation of foreign assets was added to the sovereign risk of doing business in those countries.
The IMF and the World Bank imposed conditions on the indebted countries in order to meet eligibility for relief, including balanced government budgets, privatisation and deregulation, a form of “austerity” for already poor countries. As increasingly recognised by the institutions themselves, these measures often exacerbated the situation and served to limit economic development. The Asian crisis of the early 1990s was a case in point.
It has taken a long time to write off even some of the foreign debt of the most highly indebted poor countries.
And then there was the GFC
More recently sovereign risk has come to mean the risk which arises when governments engage in expansionary fiscal and/or monetary policy in response to downturns.
Governments increased their budget deficit (fiscal stimulus) and lowered interest rates (expansionary monetary policy, quantitative easing) in response to the GFC. The intent was to expand household and other expenditure in order to drive increased production and thereby reduce unemployment. Lower interest rates were meant to encourage investment and other spending.
But this is opposed by those who argue that borrowing to fund the budget deficit will increase government debt and the costs of debt service. It is this belief which is driving the current austerity budget measures, widely countered by mainstream economists.
These austerity measures are premised on a belief that government spending is wasteful, and cutting government spending and/or increasing taxes is necessary to reduce government borrowing. It ignores that reductions in government spending would raise costs to businesses and increase their risk of bankruptcy, creating more unemployment. It could also threaten productivity in the longer run, as R&D gets less funding.
Note that this time the sovereign debt in question refers in effect to the government’s debt to itself, all denominated in domestic currency. It is not foreign currency debt, which remains small in Australia’s case. To the extent that government debt is internal it can be neutralised through monetary policy, such as buying bonds from the public. The government’s interest bill is notional, as it is with the public.
The austerity argument denies the fact that even very high levels of government debt can disappear because of increased growth in the economy arising from the initial stimulus and other factors. This has occurred many times in many economies - post World War II is the outstanding example. This is one reason why agencies which predict sovereign risk often do it badly, including the credit ratings agencies in the case of the GFC. Moreover the focus on government debt ignores the importance of private risk, arising from private holdings of debt.
Even for those who might argue a case for austerity at high levels of debt, Australia has very low levels of government debt compared to other countries which would preclude the need, as has been widely argued. In other words, this is a poor premise for sovereign risk.
The Euro crisis
In the case of the euro economies the issue is still more complex. Governments are funded from the European Central Bank (ECB), but conduct their own fiscal policies. The ECB sought repayments of euro debt which made it impossible for countries to manage and coordinate their own fiscal and monetary policies. In this case the sovereign risk is viewed as being that borne by the ECB and those dealing in the euro, yet the euro economies bear the cost of central policy failures.
Australia’s situation doesn’t quite fit
Trade Minister Andrew Robb seems to be interpreting sovereign risk as the threat to foreign confidence in doing business with Australia, driven by perceptions of exchange rate uncertainty and potential instability in the Australian economy. This is seen as arising from anything which would prevent the government from implementing its budget measures, willy nilly.
Changes to government regulation which affect the profitability of particular businesses, as in the Renewable Energy Target removal have also entered the broad church of increasing sovereign risk. It may not be wise policy, but to argue that such measures amount to a sovereign risk is drawing a very long bow indeed.
Labelling everything as “sovereign risk” is not a substitute for sensible policy to strengthen Australia’s international position.
This is the fourth piece in our series on the language of economics. Click on the links below to read the others.