tag:theconversation.com,2011:/us/topics/capital-markets-23183/articlesCapital markets – The Conversation2023-08-10T12:42:10Ztag:theconversation.com,2011:article/2110922023-08-10T12:42:10Z2023-08-10T12:42:10ZUS losing Fitch’s top AAA credit rating may portend future economic weakness<figure><img src="https://images.theconversation.com/files/541770/original/file-20230808-25-a9fldt.jpg?ixlib=rb-1.1.0&rect=132%2C150%2C6139%2C3131&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Money doesn't grow on trees for governments either.</span> <span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/photo/falling-dollar-bills-from-money-tree-royalty-free-image/157593960?adppopup=true">imagedepotpro/E+ via Getty Images</a></span></figcaption></figure><figure class="align-center zoomable">
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<p>The formerly pristine reputation of the U.S. government’s debt lost a little more luster after another prominent rating agency <a href="https://www.vox.com/2023/8/2/23817311/fitch-downgrades-us-credit-rating">demoted Uncle Sam from its AAA perch</a>.</p>
<p>What does a downgrade of U.S. creditworthiness like this actually mean?</p>
<p>While the downgrade is unlikely to have much of an impact in the short term, its implications about the state and size of U.S. indebtedness will likely reverberate on Capitol Hill, where <a href="https://apnews.com/article/congress-spending-bills-shutdown-aea04e44447fcb8a818a01a54854ac12">stalled negotiations over the budget</a> could mark a step toward the Biden administration’s first government shutdown.</p>
<p>Fitch Ratings’ decision on Aug. 1, 2023, led to small declines in the stock and bond markets. But as an economist who <a href="https://scholar.google.com/citations?user=czu6ChoAAAAJ&hl=en&oi=ao">studies the effects of monetary and fiscal policies</a>, I’ve got longer-term concerns about the downgrade’s implications for U.S. economic growth.</p>
<p>To understand why, you have to look at both the reasons for Fitch’s downgrade and what it means for U.S. borrowing going forward.</p>
<h2>Why Fitch downgraded the US</h2>
<p>Just like people, the federal government has to balance the income it takes in and the money it spends for each fiscal year. Most federal income consists of tax revenue.</p>
<p>Since 2001, <a href="https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/">that revenue has rarely covered enough</a> of the costs of everything the U.S. government pays for, from roadways to wars. When federal income falls short, the government fills the gap by borrowing money from investors. </p>
<p>That gap has gotten a lot bigger in recent years as the U.S. has spent trillions fighting COVID-19, contending with financial crises and funding several wars. As of Aug. 1, the U.S. Treasury <a href="https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny">owed US$32.6 trillion</a>, both to bondholders and other parts of the federal government. </p>
<p><a href="https://www.fitchratings.com/research/sovereigns/fitch-downgrades-united-states-long-term-ratings-to-aa-from-aaa-outlook-stable-01-08-2023">That’s part of the reason</a> that Fitch cut the U.S. government’s long-term creditworthiness by one notch, from AAA – its highest rating – to AA+. Fitch also cited an “erosion of governance,” specifically pointing to <a href="https://theconversation.com/political-compromises-like-the-debt-limit-deal-have-never-been-substitutes-for-lasting-solutions-206964">recent efforts by conservatives</a> to prevent the U.S. from raising its debt ceiling. </p>
<h2>What happened last time</h2>
<p>This was not the first time that a rating agency lowered the credit of the U.S. government. </p>
<p>In 2011, Standard & Poor’s, one of Fitch’s competitors, also <a href="https://www.cnn.com/2023/08/02/investing/premarket-stocks-trading/index.html">downgraded its rating for the U.S.</a> from AAA to AA+. S&P <a href="https://www.washingtonpost.com/business/economy/sandp-considering-first-downgrade-of-us-credit-rating/2011/08/05/gIQAqKeIxI_story.html">similarly blamed governance issues</a> – that downgrade followed a similar debt ceiling standoff – as well as the burden of rising government debt. </p>
<p>At the time, Fitch issued a warning but it didn’t cut the U.S.’s credit rating until now.</p>
<p>The 2011 episode had <a href="https://www.wsj.com/articles/SB10001424127887323984704578203593473607014">no long-term effects on financial markets</a>, including Treasury bonds – meaning investors remained happy to continue lending to the U.S. at favorable rates.</p>
<p>Does that mean Fitch’s downgrade will similarly have little long-term impact? Not necessarily.</p>
<h2>Why things might be different</h2>
<p>Any country seeking to borrow money in perpetuity needs lenders who are happy to lend.</p>
<p>For the U.S., that means it needs a constant supply of <a href="https://theconversation.com/why-the-national-debt-doesnt-matter-or-how-i-learned-to-stop-worrying-and-love-treasuries-38775">buyers for Treasury bonds</a> and the other securities it sells. These <a href="https://www.treasurydirect.gov/auctions/">securities are sold in auctions</a> and then traded on global financial markets.</p>
<p>Investors of all kinds around the world find Treasurys attractive. They’re <a href="https://www.investopedia.com/ask/answers/042215/what-are-risks-associated-investing-treasury-bond.asp">seen as safe</a>, because the U.S. government is considered less likely to default than, say, a company going bankrupt.</p>
<p><a href="https://www.fitchratings.com/">Rating agencies like Fitch</a> assess these risks and periodically adjust their credit rating scores based on their assessment on the ability of the federal government – and other borrowers – to keep up with their debt obligations.</p>
<p>“Repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management,” Fitch said in its announcement, in a reference to recurring <a href="https://theconversation.com/political-compromises-like-the-debt-limit-deal-have-never-been-substitutes-for-lasting-solutions-206964">fights among lawmakers over raising the debt ceiling</a>.</p>
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<a href="https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="American flag design on a cracked background, worn and torn." src="https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=399&fit=crop&dpr=1 600w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=399&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=399&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=501&fit=crop&dpr=1 754w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=501&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=501&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">Rifts between Republicans and Democrats are making it harder for Congress to pass budgets and get other important work done.</span>
<span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/photo/concept-american-flag-on-cracked-background-royalty-free-image/607610082?phrase=flag+fractured&adppopup=true">Delpixart/iStock via Getty Images Plus</a></span>
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<p>But if economists and financial analysts deem Treasurys to be growing riskier, then investors may become less interested in buying them. Alternatively, they may demand a higher interest rate in exchange for taking on the risk that the U.S. may default on its debts.</p>
<p>So, however the market reacts, I believe that this downgrade reflects the real deterioration of America’s fiscal standing as well as its ability to safeguard it. </p>
<p>And as economists and financial analysts decide Treasurys are becoming a riskier security to hold – whether because of the size of overall U.S. debt or because <a href="https://theconversation.com/why-america-has-a-debt-ceiling-5-questions-answered-164977">political brinkmanship</a> is making a once-unthinkinkable default more likely – then investors may become less interested in buying them. Or, at least, they may demand the U.S. pay them more to take on the risk, resulting in higher borrowing costs for the government.</p>
<p>Ultimately, this means there will be less money for everything else the U.S. might want to spend money on – or the overall debt load will rise even faster.</p>
<h2>Limited options</h2>
<p>To cover its growing borrowing costs, the federal government has few options – none good.</p>
<p>It can borrow more money, which is seen as riskier – like taking out one loan to pay off another – and could result in an even lower credit rating and a continuous spiral of rising borrowing costs. Or it could hike tax rates or cut spending, both of which have political consequences and could be hard to accomplish given the <a href="https://www.pewresearch.org/short-reads/2022/03/10/the-polarization-in-todays-congress-has-roots-that-go-back-decades/">degree of polarization in Congress</a>.</p>
<p>Furthermore, <a href="https://doi.org/10.1111/rode.12661">research has shown that higher government debt</a> is generally associated with lower long-term economic growth, which reinforces the problem by reducing revenue and thus requiring more debt. </p>
<p>So, while Fitch’s downgrade doesn’t signal an imminent financial crisis, it does serve as a warning as Congress engages in its fiscal fights – including the <a href="https://apnews.com/article/congress-spending-bills-shutdown-aea04e44447fcb8a818a01a54854ac12">one over the budget</a> that will heat up in September.</p><img src="https://counter.theconversation.com/content/211092/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Hakan Yilmazkuday does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The rating agency demoted the US government’s creditworthiness to AA+, its second-highest ranking, on Aug. 1, 2023.Hakan Yilmazkuday, Professor of Economics, Florida International UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1811392022-04-18T12:28:58Z2022-04-18T12:28:58ZRussia faces first foreign default since 1918 – here’s how it could complicate Putin’s ability to wage war in Ukraine<figure><img src="https://images.theconversation.com/files/458329/original/file-20220415-16-jlry37.jpg?ixlib=rb-1.1.0&rect=143%2C0%2C5847%2C3664&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Replacing ships like the Moskva will be pricey. The flagship of Russia’s Black Sea Fleet recently sank after suffering damage.</span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/RussiaUkraine/96ef4c8b56c24796a61a124270f573b9/photo?Query=moskva&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=643&currentItemNo=1">Russian Defense Ministry Press Service via AP</a></span></figcaption></figure><p><em>Russia may be on the cusp of <a href="https://www.npr.org/2022/04/12/1092077016/russia-historic-debt-default-sanctions-invasion-ukraine">its first default on its foreign debt</a> since the Bolsheviks ousted Czar Nicholas II a century ago.</em></p>
<p><em>On April 14, 2022, Moody’s Investors Service warned the country’s decision to make payments on dollar-issued debt in rubles <a href="https://www.nytimes.com/2022/04/14/business/russia-default-moodys.html">would constitute a default</a> because it violates the terms of the contract. A 30-day grace period allows Russia until May 4 to convert the payments to dollars to avoid default.</em></p>
<p><em>A default is one of the clearest signals that the sanctions imposed by the U.S. and other countries are having their intended effect on the Russian economy. But will it have any impact on Russia’s ability to wage war in Ukraine?</em> </p>
<p><em>We asked <a href="https://scholar.google.com/citations?user=bSApaj4AAAAJ&hl=en&oi=ao">Michael Allen</a> and <a href="https://scholar.google.com/citations?user=uLty40oAAAAJ&hl=en&oi=ao">Matthew DiGiuseppe</a>, both experts on political economy and conflict, to explain the consequences of default and what it would mean for Russian President Vladimir Putin’s war.</em></p>
<h2>Why did Russia default on its debt?</h2>
<p>The Russian government has a total of <a href="https://www.nytimes.com/2022/03/15/business/russia-debt-bonds-default.html">US$40 billion worth of debt</a> in dollars and euros, half of which is owned by foreign investors. Russia had an <a href="https://www.npr.org/2022/04/12/1092077016/russia-historic-debt-default-sanctions-invasion-ukraine">April 4 deadline to pay</a> about $650 million in interest and principle to the holders of two bonds issued in dollars.</p>
<p>Russia has plenty of cash – <a href="https://asia.nikkei.com/Politics/Ukraine-war/G-7-resists-going-after-1bn-a-day-Russian-energy-revenue">it collects the equivalent of over $1 billion a day</a> from its oil and gas deliveries alone – but has limited access to dollars because of sanctions imposed by the U.S. The Biden administration had been allowing Russia to use some of the foreign reserves <a href="https://www.nytimes.com/2022/02/28/us/politics/us-sanctions-russia-central-bank.html">it had previously frozen</a> to make debt payments. The U.S. changed course on April 5, when <a href="https://www.reuters.com/business/us-cracks-down-russian-debt-payments-latest-sovereign-payments-halted-2022-04-05/">it blocked Russia from using dollar reserves</a> held at American banks to make the debt payments. </p>
<p>That gave Russia little choice but to try to make the payments in rubles, whose value <a href="https://www.xe.com/currencycharts/?from=USD&to=RUB">has been very volatile</a> since the invasion. If Russia doesn’t switch the payments to dollars by May 4, the government will be in default on its foreign obligations for the <a href="https://doi.org/10.1111/j.1540-6563.1986.tb02008.x">first time since 1918</a>, when the Bolshevik revolutionaries took over Russia and refused to pay the country’s international creditors. Russia also defaulted in 1998 but only on its domestic debt. </p>
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<img alt="A black and white photo shows groups of men in dark coats carrying caskets on their shoulders in a snowy scene. Someone in distance holds a flag" src="https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=431&fit=crop&dpr=1 600w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=431&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=431&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=542&fit=crop&dpr=1 754w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=542&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=542&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">The last time Russia defaulted on foreign debt was during the Russian Revolution.</span>
<span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/RussiaRevolution/480b20fec8a84465a3b4bb50a3810310/photo?Query=bolsheviks&mediaType=photo&sortBy=arrivaldatetime:asc&dateRange=Anytime&totalCount=747&currentItemNo=1">AP Photo</a></span>
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<h2>What are the consequences of default?</h2>
<p>When a country defaults on a foreign loan, international investors typically become unwilling or unable to lend more money to it. Or they demand much higher interest rates. </p>
<p>Whether because of higher interest costs or an inability to borrow, this forces a country to cut spending. Less government spending <a href="https://doi.org/10.1016/j.jimonfin.2020.102257">reduces economic activity</a>, <a href="http://dx.doi.org/10.2139/ssrn.3785746">increases unemployment</a> and <a href="https://www.doi.org/10.1057/imfsp.2009.21">slows growth</a>. While some of these effects, like weaker economic growth, are often short-lived, other consequences can haunt a country for years. Trade with other countries <a href="https://www.doi.org/10.1057/imfsp.2009.21">remains below normal for an average of 15 years</a> after a default, while full exclusion from capital markets typically lasts just over eight years. </p>
<p>For example, when Argentina defaulted in 2001, the <a href="https://www.doi.org/10.1007/s11079-015-9350-3">peso plunged</a>, the <a href="https://www.doi.org/10.1080/13600810600705098">economy shrank and inflation soared</a>. <a href="https://www.nytimes.com/2001/12/20/world/reeling-from-riots-argentina-declares-a-state-of-siege.html">Riots over food broke out</a> all over the country, leading to the <a href="https://www.nytimes.com/2001/12/21/world/argentine-leader-his-nation-frayed-abruptly-resigns.html">president’s resignation</a>. Although Argentina’s <a href="https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=AR">economy had recovered by 2007</a>, the country <a href="https://www.nytimes.com/2016/04/25/business/dealbook/how-argentina-settled-a-billion-dollar-debt-dispute-with-hedge-funds.html">remained unable to borrow</a> from foreign investors, which led to default again in 2014. </p>
<p>What does this mean for Russia? The country was already <a href="https://www.reuters.com/business/russia-debt-investors-limbo-default-risk-increases-2022-04-07/">locked out of international borrowing markets</a> because of sanctions. A government official recently said Russia <a href="https://www.bloomberg.com/news/articles/2022-04-10/russia-to-halt-bond-issuance-for-rest-of-2022-siluanov-says?sref=Hjm5biAW">would also avoid borrowing domestically</a>, because a default would lead to “cosmic” interest rates.</p>
<p>But its <a href="https://www.businessinsider.com/russia-sell-oil-friendly-countries-any-price-range-ukraine-war-2022-4">significant revenue</a> from sometimes-discounted sales of oil and gas may help offset the need for borrowing in the short term, especially if it can continue to find willing buyers like India and China. On April 14, 2022, Putin acknowledged sanctions <a href="https://www.nytimes.com/live/2022/04/14/world/ukraine-russia-war-news#putin-admits-sanctions-have-hurt-russias-oil-and-gas-sector">were disrupting exports</a> and raising costs.</p>
<h2>Does Russia care if it defaults?</h2>
<p>The Russian government has been trying hard to avoid default.</p>
<p>Until April 5, it was using its precious dollars to stay current on its bond payments. And before its invasion it had built up a <a href="https://www.economist.com/graphic-detail/2022/03/02/russias-attempt-to-sanction-proof-its-economy-has-been-in-vain">significant reserve of foreign currency</a>, in large part to allow it to continue to pay back debt borrowed in dollars and euros even amid sanctions. Russia has even threatened to <a href="https://www.ft.com/content/56df1dc0-6cf3-41f8-a644-d44be5085ee8#post-9a4c235d-5382-40f9-8314-e0c19152ac92">take legal action</a> if sanctions force it into default.</p>
<p>As odd as it may sound, Russia is likely worried about its reputation – at least among bond investors.</p>
<p>A default by a sovereign borrower <a href="https://press.princeton.edu/books/paperback/9780691134697/reputation-and-international-cooperation">establishes a bad reputation</a> that can take years to rehabilitate, as Argentina’s experience shows.</p>
<p>And the long-term impact could be worse for Russia. The reason Russia is in this bind is because it chose to invade Ukraine, <a href="https://www.usnews.com/news/world-report/articles/2021-12-07/u-s-threatens-extreme-sanctions-if-russia-invades-ukraine">despite repeated warnings</a> that doing so <a href="https://www.reuters.com/world/europe/us-uk-ready-punish-putin-associates-if-russia-invades-ukraine-2022-01-31/">would result in severe</a> economic and financial sanctions.</p>
<p>So creditors might wonder if Russia will always prioritize its foreign policy interests over the interests of creditors and raise borrowing costs permanently. If so, they may find it difficult to borrow for years to come. </p>
<p>Another risk is that a default may enable creditors to seize Russia’s overseas assets as a form of repayment. International sanctions have already <a href="https://www.cnn.com/interactive/business/russian-oligarchs-yachts-real-estate-seizures/index.html">enabled countries to seize or freeze Russian assets</a>, which could be used to pay off outstanding debts.</p>
<p>One count suggests that <a href="https://voxeu.org/article/how-creditor-lawsuits-are-reshaping-sovereign-debt-markets">50% of creditors in recent sovereign debt cases</a> have attempted to <a href="https://www.reuters.com/business/finance/clock-ticks-down-towards-russian-default-2022-04-08/">seize assets as an alternative to payment</a>. </p>
<h2>What does this mean for Russia’s war in Ukraine?</h2>
<p>As long as there has been debt, governments have waged wars with other people’s money. In fact, debt has become so vital as a source of power that countries rarely fight without it.</p>
<p>Around 88% of wars from 1823 through 2003 have been at least partly financed with <a href="https://www.cornellpress.cornell.edu/book/9781501702495/how-states-pay-for-wars/#bookTabs=1">funds borrowed from banks and other investors</a>. This reality even bleeds into fantasy worlds, like “Game of Thrones,” in which financing from the Iron Bank of Braavos <a href="https://qz.com/1064757/game-of-thrones-season-7-with-the-iron-bank-a-debt-crisis-is-always-looming/">is vital to financing the wars of Westeros</a>. </p>
<p>Our own research has shown that countries that have defaulted on their debts or have poor credit ratings find it <a href="https://www.doi.org/10.1177/0022343315587970">difficult to build military capacity</a> and, consequently, are more reluctant to <a href="https://doi.org/10.1111/fpa.12044">take up arms</a> against other nations. Related work has found that countries with lower borrowing costs <a href="https://doi.org/10.1177/0022002713478567">tend to win wars</a> – though this effect is stronger for democracies. </p>
<p>One reason is that borrowing allows countries to overcome the guns-versus-butter trade-off: More money spent on the military means less for its citizens’ welfare, which can hurt a government’s ability to stay in power. Foreign loans can help overcome this problem, but losing access to credit forces a government to choose. </p>
<p>In the short term, however, a default is not likely to alter the outcome of Russia’s war – or force Putin to make any unpopular trade-offs – especially if <a href="https://www.bbc.com/news/world-europe-60938544">Russia is able to achieve</a> its <a href="https://www.aljazeera.com/news/2022/4/11/russia-repositioning-in-ukraines-eastern-donbas-region-us">new and more limited military objectives</a> in the eastern Donbas region quickly. </p>
<p>This will change the longer the war goes on. The war was expected to last only a few days, but a <a href="https://www.cnbc.com/2022/03/04/russias-invasion-of-ukraine-is-baffling-military-analysts.html">stronger-than-expected Ukrainian defense</a> has pushed the conflict into its eighth week. Early estimates found that a prolonged war <a href="https://www.consultancy.eu/news/7433/research-ukraine-war-costs-russian-military-20-billion-per-day">could end up costing Russia</a> over $20 billion a day, including both direct and indirect expenses, like loss of economic output.</p>
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<p>If Ukraine becomes a <a href="https://www.theatlantic.com/international/archive/2022/03/how-long-will-ukraine-russia-war-last/627036/">lengthy war of attrition</a>, <a href="https://www.politico.com/news/2022/03/20/ukraine-war-of-attrition-00018752">as some analysts expect</a>, then Russia’s inability to borrow money will weaken its ability to sustain, supply and reinforce its position in Ukraine – especially if <a href="https://www.businessinsider.com/russia-sell-oil-friendly-countries-any-price-range-ukraine-war-2022-4">oil prices fall</a> or the <a href="https://www.nytimes.com/live/2022/04/14/world/ukraine-russia-war-news/europe-starts-drafting-a-ban-on-russian-oil-imports">European Union boycotts</a> or reduces its dependence on Russian fuel. </p>
<p><a href="https://doi.org/10.2968/060002010">Roman statesman Cicero wrote</a>: “Nervos belli, infinitam pecuniam,” which loosely translates as “Successful war-waging capacity requires unlimited cash.”</p>
<p>And that means borrowed money. Wars usually end quickly without it.</p><img src="https://counter.theconversation.com/content/181139/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Michael A. Allen has received funding from the Department of Defense's Minerva Initiative, the US Army Research Laboratory, and the US Army Research Office.</span></em></p><p class="fine-print"><em><span>Matthew DiGiuseppe receives funding from the European Research Council. </span></em></p>Russia is on the verge of defaulting on its foreign debt, which not only could have severe economic consequences but could also complicate Putin’s ability to wage a prolonged war in Ukraine.Michael A. Allen, Associate Professor of Political Science, Boise State UniversityMatthew DiGiuseppe, Assistant Professor of International Relations, Leiden UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1507922020-12-15T13:20:55Z2020-12-15T13:20:55ZCOVID-19 further exposes inequalities in the global financial system<figure><img src="https://images.theconversation.com/files/373627/original/file-20201208-21-18ted22.jpg?ixlib=rb-1.1.0&rect=65%2C59%2C3856%2C2389&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">A grant from the Chinese government will make way for a multimillion-dollar fishing port complex in Accra, Ghana.</span> <span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/news-photo/residents-and-traders-from-the-james-town-community-are-news-photo/1215198855?adppopup=true">Nipah Dennis/AFP via Getty Images</a></span></figcaption></figure><p>To stem the <a href="https://unctad.org/news/covid-19s-economic-fallout-will-long-outlive-health-crisis-report-warns">economic fallout from COVID-19</a>, developed countries have injected an unprecedented <a href="https://blogs.imf.org/2020/05/20/tracking-the-9-trillion-global-fiscal-support-to-fight-covid-19/">US$9 trillion into their economies</a>. </p>
<p><a href="https://www.msn.com/en-xl/news/other/imf-chief-urges-g20-leaders-to-maintain-policy-support-as-global-economy-not-out-of-the-woods/ar-BB1bfXaZ">The International Monetary Fund</a> has recommended sustained fiscal support, emphasizing greater spending on <a href="https://www-ft-com.eur.idm.oclc.org/content/9dd38ca3-a07b-4905-813d-39261dbc3c91">health care and environmental protection projects</a>.</p>
<p>Meanwhile, countries in the “global south” – broadly, low- and middle-income countries in Latin America, Asia and Africa – face <a href="https://blogs.imf.org/2020/08/27/covid-19-without-help-low-income-developing-countries-risk-a-lost-decade/">more dire circumstances</a>. They don’t have the ability to inject that level of cash into their economies. </p>
<p>And it’s not only because their economies are poorer. </p>
<p>As an <a href="https://stockton.academia.edu/RamyaVIjaya">economics professor</a>, I focus on the systemic <a href="https://www.credit-suisse.com/about-us/en/reports-research/global-wealth-report.html">inequalities in the global financial system</a> that block such access in developing economies. </p>
<p>With a greater public awareness of soaring <a href="https://www.weforum.org/agenda/2020/10/covid-19-is-increasing-multiple-kinds-of-inequality-here-s-what-we-can-do-about-it/">inequality within countries</a>, it is also important to recognize the deep <a href="https://www.brookings.edu/research/the-international-monetary-and-financial-system-how-to-fit-it-for-purpose/">imbalances across the global financial system</a>. </p>
<h2>Inaccessible financing</h2>
<p>Fiscal support in developed economies is often financed by deficit spending and government borrowing. Countries like the United States finance a major part of deficits by borrowing from companies and central banks within their own countries. Such borrowing remains in the countries’ own currency, making them less risky.</p>
<p>The <a href="https://www.imf.org/en/Publications/FM/Issues/2020/09/30/october-2020-fiscal-monitor">fiscal deficit</a> in advanced economies – a <a href="https://www.imf.org/en/Publications/WEO/weo-database/2020/October/select-aggr-data">group of 39 nations</a> including the U.S., European countries and Japan – is projected to expand to 14.4% in 2020 from 3.3% in 2019, according to the IMF.</p>
<p>This deficit financing is practically inaccessible to developing economies, given the extreme inequalities in <a href="https://www.credit-suisse.com/about-us/en/reports-research/global-wealth-report.html">global wealth</a>. These nations secure most of their deficit financing through lending from multilateral agencies like the International Monetary Fund. Or they borrow dollars in international capital markets. They then have to pay back the debt in dollars, which makes the loans more expensive if the value of their own currency drops.</p>
<h2>Not all debt is equal</h2>
<p>During the <a href="https://www.brookings.edu/research/is-sub-saharan-africa-facing-another-systemic-sovereign-debt-crisis/">2008 financial crisis</a>, the limited availability of multilateral lending forced low-income countries – <a href="https://www.odi.org/blogs/10680-africa-10-years-after-global-financial-crisis-what-we-ve-learned">particularly in Africa</a> – to fund recovery efforts and infrastructure expansion by borrowing dollars in private markets. </p>
<p><a href="http://speri.dept.shef.ac.uk/2013/10/28/caribbeans-silent-debt-crisis/">Caribbean nations</a> also relied on private loans to recover from the financial crisis and <a href="https://www.reuters.com/article/us-climate-change-islands-covid-trfn-idUSKBN265327">multiple hurricanes</a>. </p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/373649/original/file-20201208-14-h3ifjm.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/373649/original/file-20201208-14-h3ifjm.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/373649/original/file-20201208-14-h3ifjm.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=337&fit=crop&dpr=1 600w, https://images.theconversation.com/files/373649/original/file-20201208-14-h3ifjm.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=337&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/373649/original/file-20201208-14-h3ifjm.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=337&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/373649/original/file-20201208-14-h3ifjm.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=424&fit=crop&dpr=1 754w, https://images.theconversation.com/files/373649/original/file-20201208-14-h3ifjm.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=424&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/373649/original/file-20201208-14-h3ifjm.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=424&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">Low-income countries like Guatemala rely heavily on private loans to recover from natural disasters like Hurricane Eta and Hurricane Iota.</span>
<span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/news-photo/aerial-view-of-a-flooded-town-on-november-09-2020-in-san-news-photo/1284741280?adppopup=true">Jouse Decavele/Getty Images</a></span>
</figcaption>
</figure>
<p>To reimburse these loans, low-income countries <a href="https://jubileedebt.org.uk/countries-in-crisis/ghana-debt-crisis-rooted-colonialism">depend on money they make</a> from the exportation of raw materials, or commodities, and tourism, which are paid in U.S. dollars.</p>
<p>Dependence on the sale of commodities, an outcome of trade patterns established by the European colonization of the global south in the 19th century, is often associated with <a href="https://unctad.org/system/files/official-document/cimem2d37_en.pdf">economic instability</a>. </p>
<p>The <a href="https://www.un.org/africarenewal/magazine/december-2016-march-2017/commodity-prices-crash-hits-africa">2014 crash in commodities prices</a>, for example, caused big declines in dollar earnings in the global south. It also led to a fall in the currency values of commodities exporters.</p>
<p>Consequently, interest payments and the value of dollar-denominated debt increased in countries like <a href="https://jubileedebt.org.uk/history-of-debt">Ghana and Mozambique</a>. The commodities crash also increased debt burdens in such countries as <a href="https://blogs.ei.columbia.edu/2020/03/18/covid-19-oil-price-war-latin-america/">Brazil and Mexico</a>. Facing a sudden devaluation of their currencies and lower export earnings, many countries had to borrow more to continue to service previous loans.</p>
<p>Payments on external debt as a percentage of government revenues also ballooned. </p>
<p>Though low-income economies borrow less compared with their GDPs – <a href="https://theconversation.com/the-us-economy-produced-about-21-7-trillion-in-goods-and-services-in-2019-but-what-does-gdp-really-mean-130685">an estimate of the value of the goods produced by their economies</a> – payment burdens are greater because most payments are external and have to be made in dollars.</p>
<p>Ghana’s debt-to-GDP ratio in 2018, for example, was <a href="https://www.imf.org/external/datamapper/CG_DEBT_GDP@GDD/SWE">59.3%</a> compared with 90.5% for the United States. As a group, the debt-to-GDP ratio in low-income economies – usually defined as countries with per capita income of <a href="https://datahelpdesk.worldbank.org/knowledgebase/articles/906519-world-bank-country-and-lending-groups">less than $1,000</a> – averaged about 20%, <a href="https://www.imf.org/en/Publications/FM/Issues/2020/04/06/fiscal-monitor-april-2020#Chapter%201">according to the IMF</a>. That compares with 105% in advanced economies. These numbers contradict the view that low-income countries tend to overborrow. </p>
<p>Yet because of exchange rate risks and dollar payments, Ghana’s ratio of external payments to revenue, for example, rose from 10% in 2014 to <a href="https://data.jubileedebt.org.uk">40%</a> in 2018. </p>
<p>These rising ratios also led to downgrades in credit ratings by private rating agencies and classifications of high risk status by the IMF’s Debt Sustainability Framework.</p>
<p><a href="https://www.brettonwoodsproject.org/2017/12/debt-sustainability-review-tinkering-around-edges-crises-loom/">Critics have denounced the Debt Sustainability Framework</a> for focusing on payment capacity and viewing all debt equally. They say that the IMF should distinguish between debt that is wasteful, such as recurring administrative expenses, and debt that funds crucial <a href="https://sites.law.duke.edu/thefinregblog/2020/08/05/between-the-devil-debt-and-the-deep-blue-sea-why-the-global-south-needs-reparations-for-the-climate-crisis/">infrastructure, health and climate crisis projects</a>.</p>
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<p>Meanwhile, ratings downgrades led to higher costs for the new loans, as lenders sought <a href="https://www.brettonwoodsproject.org/2017/12/debt-sustainability-review-tinkering-around-edges-crises-loom/">higher rates</a> to mitigate greater perceived risk. </p>
<p>This, in turn, set off a new cycle of higher debt burdens. </p>
<h2>Calls for debt relief</h2>
<p>Amid COVID-19, key dollar-earning sectors in developing countries – <a href="https://www.un.org/development/desa/dpad/publication/world-economic-situation-and-prospects-may-2020-briefing-no-137/">tourism, commodities exports and remittances</a> – are projected to take deep hits. <a href="https://www.group30.org/">Group of 30</a>, a research forum of prominent economists, expects a <a href="https://group30.org/publications/detail/4799/">$150 billion</a> decline for low-income countries. </p>
<p>This has set off another wave of credit rating downgrades that will make borrowing prohibitively expensive. </p>
<p>The African Peer Review Mechanism, a <a href="https://www.aprm-au.org/page-about/">panel set up by the African Union</a>, recently <a href="https://www.bloomberg.com/news/articles/2020-10-29/african-review-panel-slams-ratings-firms-for-covid-19-downgrades">protested</a> these downgrades for blocking efforts to mobilize fiscal resources amid the pandemic. </p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/373630/original/file-20201208-24-1fsbvfb.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/373630/original/file-20201208-24-1fsbvfb.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/373630/original/file-20201208-24-1fsbvfb.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=408&fit=crop&dpr=1 600w, https://images.theconversation.com/files/373630/original/file-20201208-24-1fsbvfb.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=408&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/373630/original/file-20201208-24-1fsbvfb.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=408&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/373630/original/file-20201208-24-1fsbvfb.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=512&fit=crop&dpr=1 754w, https://images.theconversation.com/files/373630/original/file-20201208-24-1fsbvfb.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=512&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/373630/original/file-20201208-24-1fsbvfb.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=512&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">A credit rating downgrade may force the Moroccan government to abandon plans to expand health care spending during the pandemic.</span>
<span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/news-photo/workers-from-the-moroccan-ministry-of-health-demonstrate-news-photo/1228009293?adppopup=true">Fadel Senna/AFP via Getty Images</a></span>
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</figure>
<p>In <a href="https://www.moroccoworldnews.com/2020/10/324188/credit-rating-firms-worsen-africas-economic-crisis-damage-morocco/">Morocco</a>, for example, the credit rating downgrade may force the government to scrap plans to expand health care spending during the pandemic. </p>
<p>So while advanced countries <a href="https://blogs.imf.org/2020/08/27/covid-19-without-help-low-income-developing-countries-risk-a-lost-decade/">have spent about 8% of GDP</a> on recovery efforts in 2020, low-income countries have managed an average of 1.4% of GDP. And only 0.6% of GDP has been spent in the health sector, according to the IMF.</p>
<p>Amid the pandemic, some <a href="https://www.cgdev.org/publication/plan-address-covid-19-debt-crises-poor-countries-and-build-better-sovereign-debt-system">economists have called for debt relief</a> and an expanded allocation of the IMF’s global reserve currency unit, known as Special Drawing Rights. </p>
<p>Proposed expansions of Special Drawing Rights would be allocated to each member country of the IMF. That would allow increased <a href="https://group30.org/images/uploads/publications/G30_Sovereign_Debt_and_Financing_for_Recovery_after_the_COVID-19_Shock_1.pdf">access to a global currency unit</a> and therefore reduce the need for dollar earnings.</p>
<p>I believe such measures are a necessary corrective to the disparate burdens and systemic inequalities in the global financial system.</p><img src="https://counter.theconversation.com/content/150792/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Ramya Devan does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Global economic policy excludes low-income countries from the spending options that developed nations use to buffer their economies in times of crisis, and the pandemic has inflamed that inequality.Ramya Devan, Professor of Economics, Stockton UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1374062020-05-10T08:32:15Z2020-05-10T08:32:15ZMoratorium on debt for Africa? Be careful of unintended consequences<figure><img src="https://images.theconversation.com/files/332772/original/file-20200505-83764-1hzmz2l.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">To meet the needs of its youthful population, African businesses must expand and governments must invest in infrastructure.</span> <span class="attribution"><span class="source">Getty Images</span></span></figcaption></figure><p>Africa is home to 41 of the International Monetary Fund’s 59 <a href="https://www.imf.org/en/Topics/low-income-countries">Low Income Countries</a>. These are more structurally vulnerable to external shocks such as COVID-19. The pandemic is affecting economies as governments implement increasingly aggressive lockdown procedures to stem the rate of the spread of the virus. It is also straining the continent’s generally weak national health systems.</p>
<p>At the same time the global economic slowdown triggered by the pandemic is taking a toll on key commodity sectors and tourism. These are <a href="https://www.afdb.org/en/knowledge/publications/african-economic-outlook">significant revenue earners</a> for many countries across the region.</p>
<p>As a consequence, the economic impact of COVID-19 has <a href="https://www.sciencespo.fr/psia/sites/sciencespo.fr.psia/files/Open_Letter_Sovereign_Debt_10-April-2020.pdf">sparked calls</a> from various stakeholders for a blanket moratorium (or standstill) on all debt service due to African creditors, be they bilateral, multilateral or commercial. <a href="https://www.uneca.org/sites/default/files/uploaded-documents/VC-COVID19-IMPACT-AFRICA/african_ministers_of_finance_-_covid-19_response.pdf">In a letter</a> to the international community, African finance ministers called for an immediate waiver of all interest payments on public debt and sovereign bonds. In the case of the private sector, the ministers identified the immediate waiver of all interest payments on trade credits, corporate bonds and lease payments. They also called for the activation of liquidity lines for African central banks.</p>
<p>These requests have formed the basis of <a href="https://www.project-syndicate.org/commentary/africa-needs-debt-relief-to-fight-covid19-by-ngozi-okonjo-iweala-and-brahima-coulibaly-2020-04">a growing narrative</a> for a blanket debt moratorium for Africa. The IMF and World Bank have thus far not publicly supported this call. They have instead asked bilateral and multilateral creditors in International Development Association countries to provide <a href="https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/16/39/Debt-Sustainability-Framework-for-Low-Income-Countries">debt forbearance</a>. </p>
<p>These initiatives resulted in <a href="https://g20.org/en/media/Documents/G20_FMCBG_Communiqu%C3%A9_EN%20(2).pdf">a G-20 communiqué</a> announcing a debt suspension initiative jointly agreed with the Paris Club. This stance has provided a measure of assurance to commercial and private lenders. Just like the IMF and World Bank, commercial and private lenders recognise the unintended consequences a blanket debt moratorium could have. However, commercial creditors know they need to play a role due to the magnitude and the unprecedented nature of the phenomenon that we are currently facing.</p>
<p>But if the debt suspension initiative is applied as a general blanket solution, it risks costing African countries much of the hard won gains many have achieved over the past 15 years. These gains relate to access to international capital markets and the relatively lower cost of borrowing. Many African countries have been able to access international commercial finance for the first time during this period. This has not only broadened the pool of capital they can tap, but aided in the building of a credit history in the international financial markets. As a result some governments have seen reductions in their cost of debt (for example, Ghana managed to lower the interest rates on its Eurobond issuances since 2015). </p>
<p>Nor would the proposed blanket moratorium be a victimless action. A significant proportion of the pool of international capital is derived from private and state pension schemes, educational endowments, foundations and charitable trusts. Such institutions have a fiduciary duty to make investment decisions for the benefit of their beneficiaries. These include some of the most vulnerable in society, both in developed and developing economies, such as the elderly, as well as a vast array of employees (some of whom are low paid) who are saving for their retirement. Losses from their investments will affect many materially.</p>
<h2>What’s been gained</h2>
<p>Gains over the past 15 years have not just been in terms of pricing. Some governments (such as Ghana, Nigeria and Kenya) have even managed to issue bonds <a href="https://www.bondvigilantes.com/blog/2020/01/29/can-africas-wall-of-eurobond-repayments-be-dismantled/">with much longer maturities</a> in the Eurobond markets. </p>
<p>In addition, international commercial investors have helped to develop and deepen <a href="http://documents.worldbank.org/curated/en/129961580334830825/pdf/Staff-Note-for-the-G20-International-Financial-Architecture-Working-Group-IFAWG-Recent-Developments-On-Local-Currency-Bond-Markets-In-Emerging-Economies.pdf">local currency credit markets</a>. The development of local currency bond markets has enabled African government administrations to borrow locally. This has reduced their reliance on bilateral and multilateral lenders or using short-term paper instruments. Short-term paper instruments have to be repaid within a year from the date of issue. </p>
<p>Access by African governments to domestic bond markets as well as global financial markets is very important to the continued and sustainable development of African economies. The pool of capital that these markets provide is substantially larger than the developmental finance or multilateral resources. In other words, the size of the global debt capital markets <a href="https://www.sifma.org/wp-content/uploads/2019/09/2019-Capital-Markets-Fact-Book-SIFMA.pdf">dwarfs</a> the size of the resources of the multilateral organisations.</p>
<p>Even if market access were maintained after a blanket debt moratorium for Africa, it would probably come at a higher cost of borrowing.</p>
<p>Moreover, given that most hard currency debt for the private sector is benchmarked off the sovereign, this has the potential to significantly increase financing costs to growing businesses across the region. Hence the repercussions of this action are not just for governments but businesses too. For a continent with such a young demographic, taking actions that would likely increase the cost of much needed funding for business expansion or infrastructure investments can be very costly. The expansion of businesses and investments in infrastructure are the engines of growth and job creation.</p>
<h2>Answers to a solution</h2>
<p>In drawing up workable solutions, there needs to be clear recognition of the crucial role commercial creditors will play in assisting Africa out of the current crisis and beyond. </p>
<p>The obvious question is where the capital will come from to fund the government deficits. A rough estimate puts the cost of the pandemic above the US$4 trillion mark. Even at a trillion dollars it is unlikely that the IMF’s balance sheet will be enough to help all African countries to reach a more sustainable path.</p>
<p>In this context it would be ideal to mobilise commercial lenders and investors to help bridge the financing gap many low income countries, especially those in Africa, are likely to face. </p>
<p>It is rational to expect that lenders and investors understand that time is of the essence and that breathing time is needed. So, in these unprecedented times, lenders and investors need to join the dialogue and be part of the solution to prevent unintended consequences that can be costly for Africa.</p><img src="https://counter.theconversation.com/content/137406/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Rodrigo Olivares-Caminal does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>A blanket solution to Africa’s debt burden risks costing African countries dearly in terms of access to international capital markets and the relatively lower cost of borrowing.Rodrigo Olivares-Caminal, Professor of Banking and Finance Law, Queen Mary University of LondonLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1226212019-08-30T09:17:12Z2019-08-30T09:17:12ZAssessing Jokowi’s $33-billion project to move Indonesia’s capital for the country’s economic development<figure><img src="https://images.theconversation.com/files/290242/original/file-20190830-115412-4la6p7.jpg?ixlib=rb-1.1.0&rect=1%2C0%2C997%2C664&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Jakarta’s shortcomings as a capital are obvious: it has headline-grabbing problems with congestion, pollution, and land subsidence. </span> <span class="attribution"><span class="source">www.shutterstock.com</span></span></figcaption></figure><p>Indonesian President Joko “Jokowi” Widodo, known for various infrastructure projects during his tenure, is embarking on another mega-project yet with his plan to <a href="https://www.bloomberg.com/news/articles/2019-08-26/jokowi-picks-borneo-for-new-capital-as-jakarta-nears-gridlock">build a brand-new national capital in East Kalimantan province on the island of Borneo</a>. </p>
<p>The estimated cost to relocate the capital 1,400 kilometers away from Jakarta is <a href="https://www.washingtonpost.com/business/energy/why-indonesia-is-shifting-its-capital-from-jakarta/2019/08/26/5be9427e-c7dd-11e9-9615-8f1a32962e04_story.html">US$33 billion</a>, or around <a href="https://jakartaglobe.id/context/jokowi-announces-location-of-indonesias-new-capital/">18%</a> of Indonesia’s <a href="https://www.reuters.com/article/us-indonesia-president-budget/indonesia-president-proposes-178-billion-budget-for-2020-with-focus-on-education-idUSKCN1V60KI">$178 billion state budget</a>.</p>
<p>Jokowi hinted a sense of urgency in his decision, saying that the construction will start next year, as the <a href="http://www.futuredirections.org.au/publication/jakarta-predicted-to-become-the-worlds-most-populous-city-in-2030-some-opportunities-and-challenges/">polluted and sinking Jakarta is under considerable pressure as a capital city</a>. He announced a site and relocation plan on Monday. </p>
<p>But Jakarta’s problems may not be the only reason for Jokowi’s plan to move the capital. We can also see his move as an effort to shift economic activity and address infrastructure gaps in Indonesia’s side of Borneo, sealing his reputation as the country’s ‘<a href="https://www.economist.com/asia/2018/05/05/indonesias-leader-jokowi-is-splurging-on-infrastructure">infrastructure president</a>’ </p>
<h2>Indonesia’s infrastructure gaps</h2>
<p>As an archipelago, Indonesia’s economic activities are spread unevenly across islands – and so are its infrastructure projects. </p>
<p>Java Island, where Jakarta is situated, dominates the country’s economic activities. It is home to almost <a href="https://www.bloomberg.com/news/articles/2019-08-26/jokowi-picks-borneo-for-new-capital-as-jakarta-nears-gridlock">60%</a> of Indonesia’s population and contributes about <a href="https://www.bloomberg.com/news/articles/2019-08-26/jokowi-picks-borneo-for-new-capital-as-jakarta-nears-gridlock">58%</a> of its gross domestic product (GDP). Sumatra has about 19% of the population and its contribution to <a href="https://www.indonesia-investments.com/id/news/todays-headlines/indonesias-most-populous-island-of-java-continues-to-dominate-the-economy/item972">GDP hovers around 23%</a>. Meanwhile, Kalimantan accounts for <a href="https://www.bloomberg.com/news/articles/2019-08-26/jokowi-picks-borneo-for-new-capital-as-jakarta-nears-gridlock">5.8%</a> of the population and contributes <a href="https://www.bloomberg.com/news/articles/2019-08-26/jokowi-picks-borneo-for-new-capital-as-jakarta-nears-gridlock">8.2%</a> of GDP.</p>
<p>Foreign investors, which Jokowi targets to develop the country’s emerging industries, also mostly operate in Java. Japan, a top investor in Indonesia, channels 93% of its investment to Java. <a href="https://perthusasia.edu.au/events/past-conferences/defence-forum-2019/2019-indo-pacific-defence-conference-videos/keynotes-and-feature-presentations/pu-134-japan-book-web.aspx">Only 1% currently goes to Kalimantan</a>.</p>
<p>Given Java and Sumatra’s economic dominance, it is no surprise they have the highest concentration of infrastructure, <a href="https://drive.google.com/open?id=1R2JXANlCvp0vlAKdk3hRl1iVnlqquhmP&usp=sharing">dotted with numerous road, highway, and toll road projects</a> to help smooth the movement of millions of people and goods. </p>
<p>According to the country’s <a href="https://kppip.go.id/en/national-strategic-projects/">National Strategic Projects pipeline</a>, Java and Sumatra have 154 projects planned compared to 79 in the rest of the country</p>
<p>Meanwhile, infrastructure projects in Kalimantan were almost nonexistent until Jokowi’s presidency. </p>
<p>Under Jokowi, East Kalimantan has <a href="https://en.tempo.co/read/920117/east-kalimantan-railway-investment-to-be-discussed-in-russia">railways</a> planned and a <a href="https://www.thejakartapost.com/news/2019/02/17/kalimantans-first-toll-road-to-be-opened-in-august.html">toll road</a> between the cities of Balikpapan and Samarinda under construction near the proposed site. </p>
<h2>Betting on the new capital</h2>
<p>To build a new capital, the government must upgrade existing city infrastructures and plan new projects in the region <a href="https://perthusasia.edu.au/our-work/building-bridges-navigating-indonesias">to support businesses</a>. Otherwise, Jokowi won’t be able to achieve his growth targets and connect Indonesia’s new capital with the global economy.</p>
<p>Jokowi seems to be betting on the idea that relocating the bureaucracy of the world’s third-largest democracy would bring a critical mass of supporting institutions, industries, and investment to enrich a province on the outside of the Java-Sumatra core. </p>
<p>The relocation plans include moving the headquarters of <a href="https://www.thejakartapost.com/news/2019/08/27/jokowi-picks-east-kalimantan.html?src=mostviewed&pg=/">powerful ministries and institutions</a> to the new capital starting in 2024. </p>
<p>Diplomatic missions to Indonesia and the ASEAN Secretariat, based in Jakarta, would <a href="https://www.thestar.com.my/news/regional/2019/08/26/jakarta-based-diplomats-question-capital-move">presumably relocate as well</a>. </p>
<h2>Development initiatives in Kalimantan</h2>
<p>Indonesian firms, mostly state-owned firms (SOEs) will likely be the first to break ground in East Kalimantan next year. </p>
<p>They are currently <a href="https://www.economist.com/asia/2018/05/05/indonesias-leader-jokowi-is-splurging-on-infrastructure">building and managing 80%</a> of Indonesia’s infrastructure projects. </p>
<p>Using state companies is a convenient way to expedite new projects because the government often has <a href="https://www.newmandala.org/building-a-better-infrastructure-policy-after-indonesias-elections/">direct influence over the firm</a>. </p>
<p>It also bypasses slow processes like project proposal designs and competitive tendering. But, relying on state companies to lay the foundations for a new city in a comparatively remote region like East Kalimantan has its drawbacks. Overreliance crowds out much-needed private investment and undermines the benefits of competition among contractors. Indonesia’s business community has <a href="https://finance.detik.com/berita-ekonomi-bisnis/d-3673862/kritik-bumn-kuasai-proyek-pengusaha-kita-mau-jadi-pemain-utama">echoed these sentiments</a>.</p>
<p>Meanwhile, a big question hangs over how the Indonesian government will involve competing infrastructure and connectivity initiatives such <a href="https://www.cfr.org/backgrounder/chinas-massive-belt-and-road-initiative">China’s Belt and Road Initiative (BRI)</a> and <a href="https://www.mofa.go.jp/policy/oda/page18_000076.html">Japan’s Partnership for Quality Infrastructure (PQI)</a> in the construction of the new capital. </p>
<p>The World Bank and Asian Development Bank have long provided much-needed capital and technical assistance in Indonesia, while the China-led Asian Infrastructure Investment Bank (AIIB) is a newcomer.</p>
<p>Indonesia has invited China’s BRI to invest in projects in adjacent North Kalimantan province, in particular a <a href="https://www.thejakartapost.com/news/2018/04/19/powerchina-to-build-hydropower-plants-for-17-8-billion.html">$17.8 billion hydropower project</a>. </p>
<p>BRI is known for its willingness to pursue projects in challenging regions, but the initiative has suffered from credibility problems in Indonesia. BRI’s flagship project in Indonesia, a high-speed train connecting Jakarta and Bandung, West Java has failed to meet deadlines and officials have begun to view the management of the project as <a href="https://www.bloomberg.com/news/articles/2019-03-31/indonesia-may-be-next-asian-country-to-spurn-china-in-election">non-transparent</a>.</p>
<h2>Bankability challenges</h2>
<p>To attract more investment for the development of the new national capital, Indonesia needs to solve its bankability problem in infrastructure projects, where lenders are not satisfied enough with the project’s risk profile to invest in it. </p>
<p>Developing a pipeline of bankable projects is an opportunity to engage with the above-mentioned infrastructure initiatives. Well-designed projects that estimate everything from a project’s profitability to its environmental and social impact will be key.</p>
<p>Moving the capital to East Kalimantan promises to disrupt the present geographic spread of development in Indonesia. Jokowi has created an occasion to turn a peripheral region into a new core of economic activity. The infrastructure demands of building a new capital city afford Jokowi yet another opportunity: to call on the resources of Indonesia’s neighbours in the Indo-Pacific region and put their competing infrastructure initiatives to work.</p><img src="https://counter.theconversation.com/content/122621/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Kyle Springer receives funding from the Western Australian State Government and Australian Federal Government. Perth USAsia Centre also receives funding from corporate partners: <a href="https://perthusasia.edu.au/our-partners">https://perthusasia.edu.au/our-partners</a> </span></em></p>Indonesian President Joko “Jokowi” decision to relocate the country’s capital is seen as an effort to shift economic activity and address infrastructure gaps outside of Java and Sumatra.Kyle Springer, Senior Analyst at the Perth USAsia Centre, The University of Western AustraliaLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1191892019-06-30T18:08:54Z2019-06-30T18:08:54ZFamily firms’ need for control and equity financing decisions<figure><img src="https://images.theconversation.com/files/280435/original/file-20190620-149847-1di14q9.jpg?ixlib=rb-1.1.0&rect=0%2C5%2C1280%2C845&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">L’Oréal headquarters in Clichy, France. The firm is family owned, and while it has extensive experience in capital markets, many other family-owned enterprises are hesitant to take such a step.
</span> <span class="attribution"><a class="source" href="https://upload.wikimedia.org/wikipedia/commons/thumb/a/a1/Extension_si%C3%A8ge_L%27Or%C3%A9al_%2843707042205%29.jpg/1280px-Extension_si%C3%A8ge_L%27Or%C3%A9al_%2843707042205%29.jpg">Arthur Weidmann/Wikimedia</a>, <a class="license" href="http://creativecommons.org/licenses/by/4.0/">CC BY</a></span></figcaption></figure><p><em>This article was co-written by European School of Management and Technology’s Bianca Schmitz and Warwick Business School Professor Johannes Habel.</em></p>
<hr>
<p>Wal-Mart, Volkswagen, Bosch, Aldi, Dell, LVMH, Ikea, Mars, Nike, and L'Oréal are not only well-known firms, they’re also all family businesses. Worldwide, family firms are the leading form of economic enterprise and responsible for a major part of economic growth. And while many of these family firms flourish, financing and especially equity-based financing is a major issue for them.</p>
<p>As Cascadia Capital managing director Christian Schiller <a href="https://www.seattlebusinessmag.com/business-corners/family-business/whole-new-world-options-your-family-business">explains</a>: </p>
<blockquote>
<p>“Many family businesses that missed the 2007 peak market window are now able to reconsider their liquidity and succession alternatives, given the valuation of their business has likely risen back to and above the levels they saw pre-2008.”</p>
</blockquote>
<p>The passage in December 2017 of a US tax revision that <a href="https://www.reuters.com/article/us-usa-tax-privateequity/u-s-tax-curbs-on-debt-deduction-to-sting-buyout-barons-idUSKBN1EF1G5">limits deductions on debt interest</a> could hurt family-business entrepreneurs who rely on this forward-focused capital in order to innovate and expand. In response, an executive of a private equity (PE) fund – an investment vehicle that invests in enterprises not listed on a public stock exchange) <a href="https://www.entrepreneur.com/article/307999">stated</a> that “family-business entrepreneurs should embrace private equity funding.”</p>
<h2>An unrequited attraction</h2>
<p>Family firms are increasingly attracting investors’ interest because they are the dominant form of economic enterprise and often do not have the necessary financial resources to survive or grow.</p>
<p>Despite investors’ strong interest, firm owners are often reluctant to offer equity in the capital markets. According to the <a href="https://eynewsletters.ey.com/2018/1802/1802-2595026/index.html">EY 2018 Family Business</a> report, only 38% of the world’s largest family businesses have either used or are currently using private equity as a source of capital. Studies have repeatedly shown that family firms are less likely to use external equity as a source of financing than non-family firms.</p>
<p>Prior studies have argued that family firms are reluctant to consider external equity as a source of financing because they fear a loss of control. However, prior empirical research has neglected potential contingencies that determine whether family firms’ need for control affects their equity financing decisions. Providing a first insight into this research void is the purpose of <a href="https://doi.org/10.1108/JFBM-08-2018-0021">our article</a> published in the journal <em>Family Business Management</em>.</p>
<h2>Potential interference and emotions matter too</h2>
<p>Based on <a href="https://assets.kpmg/content/dam/kpmg/pdf/2014/09/family-business-financing-growth.pdf">data from 125 family firms of varying sizes and industries</a>, it includes published records and interviews with senior executives. The study shows that a full understanding of family firms’ consideration of external equity does not emerge from examining direct effects or even two-way interactions. Rather, this consideration is largely driven by a three-way interplay derived from <a href="https://en.wikipedia.org/wiki/Rational_choice_theory">rational choice theory</a>.</p>
<p>We show that the effect of family firm owners’ need for control on their consideration of external equity depends on the extent to which owners expect investors to interfere with management, and the extent to which decision-making is affected by emotions. The family indicates that family firm owners who tend to make decisions emotionally are less likely to systematically evaluate whether their goals (that is, maintaining control) and a course of action (such as issuing equity to external investors) are without contradiction (which may be the case if investors are unlikely to interfere with management). Instead, owners may be more likely to base their consideration of external equity on their need for control alone. </p>
<p>In other words, even if expected investor interference is low, we found a more negative relationship between need for control and consideration of external equity for family firms that base decisions on emotions, than for family firms that do not base their decisions on emotions. Thereby, the present study contrasts prior research by showing that need for control does not automatically reduce a family firm’s consideration of external equity, and provides evidence that family firm owners’ decisions to use external equity are more complex than previously presumed.</p>
<h2>Managerial implications</h2>
<p>First, investors need to understand the complex interplay at work among family firms’ need for control, expected investor interference and emotional decision-making, to correctly assess their chances of success when approaching them for equity.</p>
<p>For example, if family firm owners have a high need for control and are rational decision-makers, aspiring investors need to focus on maintaining owners’ sense of influence and control. Therefore, we recommend that investors first analyse how important different aspects of control are to owners and to themselves – such as voting rights, seats on the board, special veto rights, information rights, performance-related options, or covenants. Based on this analysis, investors may engage in multiple-issue negotiations with owners, aiming for solutions by compromising on those aspects of control that are important to owners but less important to themselves. Furthermore, investors may focus on the managerial benefits they bring into the firm, such as their mediating competence in resolving conflict between family members.</p>
<p>For family firm owners, our findings suggest that achieving a better understanding of their underlying motivations for seeking external funding might be a worthwhile investment of time. Specifically, owners should develop a clear picture about which aspects of control are important to them, to what extent external investors may pose a threat to these aspects of control, and which managerial benefits external investors may bring to the firm. Only if owners understand these aspects can they make goal-oriented – that is, rational – decisions on whether to issue external equity, which investor profile to look for and based on what criteria to evaluate investors’ track records.</p>
<p>For third parties such as banks, which help family firms identify and connect with potential financial investors, they should active search for information on the criteria outlined above. Expected investor interference and the degree to which decisions tend to be emotional ultimately influence whether family firm owners consider offering external equity in their firms. Therefore, information on these variables is key to understanding family firms’ financing needs and advising them appropriately, for example by connecting them with potential investors or guiding them in deciding on the desirable equity-to-debt ratio.</p><img src="https://counter.theconversation.com/content/119189/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Martin Kupp ne travaille pas, ne conseille pas, ne possède pas de parts, ne reçoit pas de fonds d'une organisation qui pourrait tirer profit de cet article, et n'a déclaré aucune autre affiliation que son organisme de recherche.</span></em></p>Family firms can attract investor interest, yet owners are often reluctant to offer equity. New research indicates that concerns of potential interference and emotions are two of the key issues.Martin Kupp, Associate Professor for Entrepreneurship and Strategy, ESCP Business SchoolLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1187492019-06-16T17:23:53Z2019-06-16T17:23:53ZCanada’s financial markets are stunting our growth and undermining our future<figure><img src="https://images.theconversation.com/files/279671/original/file-20190616-158927-r3zn22.jpg?ixlib=rb-1.1.0&rect=0%2C0%2C4000%2C2994&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Embracing sustainable finance will help Canada build a green economy — and ensure all Canadians will flourish.</span> <span class="attribution"><span class="source">Gustavo Quepo/Unsplash</span>, <a class="license" href="http://artlibre.org/licence/lal/en">FAL</a></span></figcaption></figure><p>The <a href="https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance_en">European Union</a> and <a href="https://unepinquiry.org/publication/establishing-chinas-green-financial-system/">China</a> recently tabled extensive proposals for sustainable finance that will jump-start their clean innovation. While the world is moving forward, the United States is turning inwards and backwards. </p>
<p>Which direction will Canada go?</p>
<p>How Canadian industry reacts to <a href="https://www.canada.ca/en/environment-climate-change/services/climate-change/expert-panel-sustainable-finance.html">Canada’s Expert Panel on Sustainable Finance</a> will be telling. This federal government-endorsed panel has recommended policies and programs that will transition Canada’s financial sector towards sustainable growth. Canadian industry will either react with reticence and revulsion, or it will embrace the opportunity to play in international capital markets that reward a long-term outlook. </p>
<h2>What is sustainable finance?</h2>
<p><a href="https://hbr.org/2019/05/the-investor-revolution">Sustainable finance</a> is not a tax. It’s an incentive that directs the flow of capital to projects that create value for all Canadians, not just a handful of wealthy investors. </p>
<p>It encourages investors to widen their criteria in evaluating investments not just by the financial returns but also on environmental, social and governance performance grounds. Such criteria have been shown to reduce the investment risks and encourage long-term growth. These types of investments have incubated numerous new financial products, including green bonds, sustainability-leveraged loans and impact investments.</p>
<hr>
<p>
<em>
<strong>
Read more:
<a href="https://theconversation.com/green-bonds-are-taking-off-and-could-help-save-the-planet-89643">Green bonds are taking off – and could help save the planet</a>
</strong>
</em>
</p>
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<p>Currently, many investors make money off other investors. For example, <a href="https://www.lrb.co.uk/v41/n05/donald-mackenzie/just-how-fast">high-frequency trading</a> is estimated to influence 40 to 50 per cent of the volume of all assets. These traders “beat the market” by milliseconds. After an investor puts in their order to make a trade, high-frequency traders rush ahead of the investor’s trade, leading to a higher price for buyers and lower prices for sellers. </p>
<p>As well, capital markets favour short-term returns. The flight risks of short-term capital make it difficult for the corporate sector to transition to a clean economy, which often requires heavy investments in research and development and technology. </p>
<p>Sustainable finance helps solve both problems. It puts the real economy and the long term back into focus. It recognizes that speculative investor behaviours and short-term capital flows can undermine a resilient financial system and society. </p>
<h2>What if we don’t embrace sustainable finance?</h2>
<p>The failure to embrace sustainable finance will hurt all Canadians, not just capital markets. There is the risk to our economy, because it is so carbon-intensive. Canada’s economy relies heavily on natural resources. In fact, relative to all of the other G7 economies, Canada’s is the most heavily dependent of natural resources. </p>
<p>When the rest of the world transitions away from carbon, Canada’s corporations will be lassoed with a heavy load of stranded assets. The <a href="https://www.cdp.net/en">Carbon Disclosure Project</a> recently reported that the <a href="https://www.straitstimes.com/world/europe/worlds-biggest-companies-foresee-14-trillion-climate-cost-hit-report">world’s 215 largest companies anticipate that US$1 trillion are at risk from climate impacts</a>. The Bank of Canada has acknowledged <a href="https://www.theglobeandmail.com/business/commentary/article-the-bank-of-canada-declared-climate-change-a-financial-risk-now-what/">the risk to Canadians under different climate scenarios</a>.</p>
<p>Second, there is the risk to Canadians with pension plans, given the current short-term speculative behaviours of financial markets. Short-term investments undermine long-term returns. The failure to embrace sustainable finance puts at risk not just our own well-being heading into old age, but the welfare of our children. </p>
<h2>What if we do embrace sustainable finance?</h2>
<p>Sustainable finance will spur innovation that will create new, agile, clean, forward-looking businesses. These businesses will enable new technologies, such as fuel cells, platform software that links buyers and sellers, and product formulations that reduce the use of plastics and toxins. </p>
<p>However, doing so requires Canadian investors, businesses and society to look to the future of what is to come, rather than stay locked into the past. </p>
<p>There is no need for Canadians to play catch-up. We can lead. Canada’s educated, healthy and diverse workforce, along with our strong capital and physical infrastructure, puts us in an enviable position to lead innovations on the world stage. </p>
<h2>A call to government and business</h2>
<p>There’s no question sustainable finance will redirect capital and, thereby, create winners and losers. Resources will be redistributed. </p>
<p>The winners will be those who create real wealth and look to the future. The losers will be those who have profited simply through arbitrage, rather than creating real value. The winners will often be new market entrants that are small- and medium-sized. These will include the young and the old, and often those who have been left out of the traditional economy. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/279252/original/file-20190612-32335-1jm7fg3.jpg?ixlib=rb-1.1.0&rect=0%2C0%2C3008%2C1967&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/279252/original/file-20190612-32335-1jm7fg3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=399&fit=crop&dpr=1 600w, https://images.theconversation.com/files/279252/original/file-20190612-32335-1jm7fg3.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=399&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/279252/original/file-20190612-32335-1jm7fg3.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=399&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/279252/original/file-20190612-32335-1jm7fg3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=501&fit=crop&dpr=1 754w, https://images.theconversation.com/files/279252/original/file-20190612-32335-1jm7fg3.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=501&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/279252/original/file-20190612-32335-1jm7fg3.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=501&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">The winners will be those who look to the future.</span>
<span class="attribution"><span class="source">Chris Barbalis/Unsplash</span></span>
</figcaption>
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<p>But the likely losers have a vested interest in keeping the status quo. These people will fight sustainable finance, because they are anchored in the past. </p>
<p>Canadians have faced transitions before. We saw the collapse of our East Coast fisheries, the Québec and British Columbia forestry industries and, more recently, the Alberta oil and gas industry. We have shown tremendous resilience managing these previous transitions. And, through these transitions, we have found new opportunities. </p>
<p>Capital markets will open up such new opportunities. Sustainable finance will remove us from the day-to-day accelerating treadmill, which is exhausting business and eroding the health of the planet.</p>
<p>The time has come to leave the past behind and transition to a new economy that seeks long-term prosperity for all Canadians.</p><img src="https://counter.theconversation.com/content/118749/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Diane-Laure Arjaliès is a member of the academic advisory of the Principles for Responsible Investment and an Independent Expert associated with the French Social Investment Forum (FIR). </span></em></p><p class="fine-print"><em><span>Tima Bansal does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>There is no need for Canadians to play catch-up on sustainable finance. We can lead.Diane-Laure Arjaliès, Assistant Professor, Ivey Business School, Western UniversityTima Bansal, Canada Research Chair in Business Sustainability, Western UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1018592018-08-21T10:35:03Z2018-08-21T10:35:03ZHow sovereign wealth funds are inflating the Silicon Valley bubble<figure><img src="https://images.theconversation.com/files/232860/original/file-20180821-149484-1jawcyy.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Elon Musk has spoken to Saudi Arabia's sovereign wealth fund about taking Tesla private.</span> <span class="attribution"><a class="source" href="https://www.flickr.com/photos/nvidia/16660212029">NVIDIA / flickr</a>, <a class="license" href="http://creativecommons.org/licenses/by-nc-nd/4.0/">CC BY-NC-ND</a></span></figcaption></figure><p>Elon Musk jolted markets and shareholders when he tweeted his intention to take his electric car company, Tesla, private. Saudi billions, he proposed, could help the company escape the pressures of being publicly listed. In a <a href="https://www.tesla.com/blog/update-taking-tesla-private">blog post</a>, Musk said that “the Saudi Arabian sovereign wealth fund [had] approached [him] multiple times about taking Tesla private”.</p>
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<p>Oil wealth meets futuristic electric cars may sound like an odd mix. But there is growing precedent for this kind of investment from sovereign wealth funds, which are motivated by social as well as financial aims. So much so that they are disrupting how capital markets work.</p>
<p>The result could be calamitous. A look at the history of large inflows into specific asset classes does not bode well for the venture capital industry. When petrodollars were funnelled into the eurodollar market in the 1960s, it drove asset spikes <a href="https://ftalphaville.ft.com/2016/01/25/2151037/petrodollars-are-eurodollars-and-eurodollar-base-money-is-shrinking/">and then resets</a>. Similarly, Japanese investment in American real estate fuelled a spectacular bubble – and then crash – <a href="http://articles.latimes.com/1992-02-21/business/fi-2537_1_japanese-real-estate">in the early 1990s</a>. US investment bank lending in Latin American debt in the 1980s ultimately culminated in a <a href="https://www.federalreservehistory.org/essays/latin_american_debt_crisis">“decade of lost growth”</a>. </p>
<p>A typical refrain is that “this time it’s different”. But it’s never different. We argue that the global rise of sovereign wealth fund investments into venture capital is driving a similar cycle of asset inflation that will end in tears. </p>
<h2>Huge sums of money</h2>
<p>The reason that sovereign wealth fund money could prove destabilising for venture capital (VC) comes from the nature of the way VC works. Traditionally, nimble investment firms, led by experienced partners with technical and operational expertise, would identify potentially disruptive technologies and then work with the fledgling firms on strategy, hiring and product. This “smart money” is said to have catapulted Silicon Valley technology firms <a href="https://americanaffairsjournal.org/2018/08/building-the-venture-capital-state/">into global powerhouses</a>. </p>
<p>But the small scale and scrappy nature of venture capital is a relic of the 20th century. Today, VC funds are backed by some of the world’s largest investors, including funds like Saudi Arabia’s Public Investment Fund (PIF) and Singapore’s GIC. Sovereign wealth funds are investing huge sums of money, both as limited partners in VC funds and as venture capitalists themselves. </p>
<p>The entrance of sovereign wealth funds into the previous cottage industry of venture capital has fuelled <a href="http://docs.preqin.com/quarterly/pe/Preqin-Quarterly-Private-Equity-Update-Q1-2018.pdf">unprecedented levels of “dry powder”</a> (money that the VCs need to invest). With more money at their disposal than ever before, VC managers are investing more money in each deal, and making more deals. Recent quarters have seen a <a href="https://assets.kpmg.com/content/dam/kpmg/xx/pdf/2018/04/kpmg-venture-pulse-q1-2018.pdf">previously unforeseen number and size</a> of “mega deals” (deals worth more than US$1 billion). </p>
<p>This all means that when – as historical precedent shows is likely – the VC bubble bursts, the fallout will be massive. And in the wake of such a bubble burst, there will be scant capital available for the many start-ups that have raised early-stage funding on hefty valuations. Investors, including the sovereign wealth funds, will be burned by the big losses, and so unwilling to invest in risky start-ups, or in venture capital funds, for years.</p>
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<p>The increasing exposure of sovereign wealth funds to venture capital comes with national development strategies and the revival of industrial policy. State-owned investment funds have started to embrace disruptive technology investment from AI to biotech. Countries with big funds, <a href="https://www.reuters.com/article/us-usa-trade-china-policy-factbox/factbox-made-in-china-2025-beijings-big-ambitions-from-robots-to-chips-idUSKBN1HR1DK">such as China</a>, have made clear their determination to move up in the global value chain in order to keep growing.</p>
<p>In a similar fashion, big oil exporters like Saudi Arabia are keen to diversify their economies <a href="https://theconversation.com/saudi-arabias-liberal-crown-prince-is-a-year-into-his-tenure-how-is-he-doing-99743">away from oil</a>. Saudi Arabia’s Vision 2030 strives to position the oil kingdom as a global technology and financial hub.</p>
<p>Leading the charge is Saudi Arabia’s Public Investment Fund. PIF made a US$45 billion investment in SoftBank’s mammoth US$100 billion venture capital <a href="https://www.wsj.com/articles/softbanks-vision-fund-hiring-deutsche-banks-chief-for-saudi-arabia-1533055230">Vision Fund</a> launched in 2017, and in June 2016, directly invested <a href="https://www.ft.com/content/a7e31c58-282c-11e6-8b18-91555f2f4fde">US$3.5 billion in Uber</a>. More recently, in March 2018, it led a late-stage VC investment of <a href="https://www.wsj.com/articles/saudi-arabia-goes-high-tech-in-approach-to-investing-1534325402">nearly US$1 billion</a> in augmented reality startup Magic Leap. Now it is in talks with Musk about <a href="https://www.wsj.com/articles/elon-musk-saudi-fund-asked-about-taking-tesla-private-1534166024">taking Tesla private</a>.</p>
<h2>Beware of the burst</h2>
<p>With the billions of dollars suddenly flowing in from sovereign wealth funds, the size of VC funds is ballooning – and so are the cheques they are writing. Early-stage, seed-round investments, which were typically US$500,000 can now be up to US$5m. </p>
<p>With so much money to invest, there is a sharp drop in the number of deals in which multiple funds participate and less of a need for start-ups to go public. This results in fewer brains being on hand to offer advice. It also means that decisions are made more quickly, with less input from multiple sources. This can be both good (decisions can be made more quickly) and bad (there are fewer checks and balances).</p>
<p>When previous floods of capital proved irresponsible, a diversification of investment opportunities – geographically and in terms of asset class – could have helped reduce the systemic risk. </p>
<p>But measures can be put in place today to neutralise the rollercoaster that sovereign wealth fund investment in venture capital is propelling, so that the global exuberance for supporting start-ups around the world proves sustainable. </p>
<p>Funds should be modest in their VC investment activity, for example, placing small bets in line with the workings of the VC industry, rather than deploying cheques in line with the size of their funds. Their appeal as buy-out partners, as Elon Musk claims, is not simply an easy alternative to the demands of being publicly listed. The long-term health of Silicon Valley and aspiring Silicon Valleys around the world depends on their discretion.</p><img src="https://counter.theconversation.com/content/101859/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Talk of Saudi Arabia helping Elon Musk take Tesla private is the latest example of a long line of sovereign wealth fund investments.Robyn Klingler-Vidra, Lecturer in Political Economy, King's College LondonJuergen Braunstein, Postdoctoral Fellow Harvard Kennedy School, Harvard UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/803482017-07-03T14:54:09Z2017-07-03T14:54:09ZWhy the World Bank’s efforts to marshal private capital won’t reduce poverty<figure><img src="https://images.theconversation.com/files/176746/original/file-20170704-32566-121zahz.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">World Bank President Jim Yong Kim is thinking about reinventing the organisation model.
</span> <span class="attribution"><span class="source">REUTERS/Yuri Gripas</span></span></figcaption></figure><p>The <a href="https://theconversation.com/the-world-bank-reinvents-itself-and-puts-poverty-reduction-at-risk-79403">planned reinvention </a>of the World Bank may be a mea culpa of sort from the multilateral funding institution. But it is still a bearer of bad news for poor African countries.</p>
<p>The World Bank is looking to migrate from the model that largely relies on member states providing loans for development projects, to one in which it becomes more of a broker of private capital to be invested in development projects. </p>
<p>The World Bank Group President <a href="http://www.lse.ac.uk/website-archive/newsAndMedia/videoAndAudio/channels/publicLecturesAndEvents/player.aspx?id=3802">Jim Yong Kim believes</a> that a sizeable portion of private capital lies idle. With proper steps to eliminate unacceptable risks, this capital can be channelled into funding development in poor countries. </p>
<p>Private investors are generally risk-averse. This means that mountains of idle cash remain largely untapped at the expense of real investments. These could generate jobs and green energy as well as reduce poverty, improve health care and extinguish debts that are haunting countries the world over.</p>
<p>Kim <a href="http://www.lse.ac.uk/website-archive/newsAndMedia/videoAndAudio/channels/publicLecturesAndEvents/player.aspx?id=3802">argues</a> that development finance needs fundamentally to change <a href="https://theconversation.com/the-world-bank-reinvents-itself-and-puts-poverty-reduction-at-risk-79403">in speed and scale</a>, growing from billions of dollars in development aid to trillions in investment.</p>
<p>As Felix Stein from the University of Cambridge and Devi Sridhar from the University of Edinburgh <a href="https://theconversation.com/the-world-bank-reinvents-itself-and-puts-poverty-reduction-at-risk-79403">point out</a>, Kim now believes that there are significant financial resources readily available and sitting on the sidelines of capital markets. They generate little in the way of returns, particularly compared to what they could make if invested in developing countries. Private investors lack knowledge about these countries, and their tendency to remain generally risk-averse means that the funds remain largely untapped. </p>
<p>Kim’s argument amounts to an admission that the Bretton Woods system has failed to address gaps in the global capital markets. And that its institutions – the International Monetary Fund and the World Bank – which were established after the second world war to foster international economic cooperation – have failed to support the world’s developmental needs.</p>
<p>But private sector funding won’t help the situation because the much needed developmental investments in Africa are social in nature. Private investments will also be costly, and as a consequence, exploitative.</p>
<h2>Weaknesses in Bretton Woods institutions</h2>
<p>The Bretton Woods multilateral institutions have been strongly criticised for their corporate led model, which tends to undermine <a href="http://www.motherjones.com/politics/2016/03/world-bank-ifc-fund-luxury-hotels/">social justice</a>. Over the years they have been focusing on profit oriented investments. Many have impoverished people in emerging economies, particularly in Asia and Africa through displacements, large scale privatisation, natural resource looting and environmental degradation. </p>
<p>Aid and loans from the World Bank and the International Monetary Fund usually come with strict <a href="https://www.imf.org/en/About/Factsheets/Sheets/2016/08/02/21/28/IMF-Conditionality">conditions and restrictive policy recommendations</a>. These take away the economic freedom of aid recipients and borrowing countries. They include strict inflation controls, high taxation, large scale privatisations, rapid trade liberalisation and cutting government expenditure on social services. </p>
<p>Conditions on aid and loans usually forfeit states’ authority in governing their own economy, as national economic policies are predetermined under the loan packages. This ultimately shifts regulation of national economies from state governments to the Washington institution in which African developing countries hold little voting power. </p>
<p>The number of emerging countries depending on the World Bank funding has drastically declined over the <a href="http://www.polity.org.za/article/why-africa-should-turn-to-capital-markets-to-fund-its-infrastructure-deficit-2015-12-07">past ten years</a>. This has been mainly due to increasingly attractive alternative sources of financing. The <a href="https://www.pambazuka.org/governance/africa-world-bank-and-imf-increasingly-irrelevant-says-africa-commission">bank has been rendered irrelevant</a> as private capital flows to the developing world have grown on the back of governments issuing sovereign bonds. Its role has gradually become a mere <a href="https://www.washingtonpost.com/business/economy/in-a-globalized-world-what-role-for-the-world-bank/2012/03/19/gIQARUhyNS_story.html?utm_term=.d4c190ca146a">aid agency </a>dealing with a smaller group of low-income fragile states,</p>
<p>The new generation of institutions spearheaded by emerging market governments led by China is further threatening the traditional multilateral <a href="https://www.economist.com/blogs/economist-explains/2014/11/economist-explains-6">institutions</a>. </p>
<p>This is what lies behind the World Bank’s efforts to reposition itself from being a lender for major development projects relying on funding states, into a broker for private sector investment. This would shift it from being a body that disburses development aid to one that mobilises investment.</p>
<p>But the World Bank’s proposed repositioning will have a number of negative implications on countries in Africa.</p>
<h2>Negative consequences</h2>
<p>First, it will further disadvantage developing nations as most investments in Africa are classified as risky. This means that most investors are unwilling to commit funds for longer time frames. And, given the high risk assessment, borrowing will be expensive. This in turn will push countries further in debt and expose them to exploitation by private lenders.</p>
<p>Second, the repositioning from public to private funding will further cement the World Bank’s business model at the expense of social benefit. This will undermine the role of the state as the primary provider of essential goods and services, such as health care and education. </p>
<p>Last, it will be almost impossible for the bank successfully to mediate between the interests of a global markets system, developing country governments, and people in poverty. This is because projects attractive for private investment are out of the reach of poor people. </p>
<p>There’s no reason to believe that the bank’s envisaged new role will lead to a reduction in poverty. The more likely outcome will be that it once again fails to address international capital market shortcomings.</p><img src="https://counter.theconversation.com/content/80348/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Misheck Mutize does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Africa should be concerned about news that the World Bank is looking to migrate from the model that largely relies on funding member states to become a broker of private capital.Misheck Mutize, Lecturer of Finance and Doctor of Philosophy Candidate, specializing in Finance, University of Cape TownLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/507822015-12-07T04:24:11Z2015-12-07T04:24:11ZWhy Africa should turn to capital markets to fund its infrastructure deficit<figure><img src="https://images.theconversation.com/files/103893/original/image-20151201-26568-197j7bg.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Viana, near Luanda, Angola. China has played a major role in funding infrastructure projects in Africa but the deficit remains huge. </span> <span class="attribution"><span class="source">Reuters/Siphiwe Sibeko</span></span></figcaption></figure><p>Improving infrastructure is not only critical for economic growth in Africa but essential for ensuring the improved wellbeing of its people. This is backed by empirical research, which shows a strong link between infrastructure development and economic <a href="http://siteresources.worldbank.org/INTAFRICA/Resources/aicd_overview_english_no-embargo.pdf">growth on the continent</a>. </p>
<p>The African Development Bank reports that road access in Africa is only 34% as compared to the 50% in other developing <a href="http://www.afdb.org/fileadmin/uploads/afdb/Documents/Generic-Documents/PIDA%20brief%20closing%20gap.pdflink">regions</a>. Just about 5% of agriculture in the region is under <a href="http://www.afdb.org/fileadmin/uploads/afdb/Documents/Generic-Documents/PIDA%20brief%20closing%20gap.pdf">irrigation</a>. In Asia, however, 37% of the agricultural land area is under <a href="http://www.eu-africa-infrastructure-tf.net/attachments/library/aicd-background-paper-9-irrig-invest-summary-en.pdf">irrigation</a> and the figure for Latin America is estimated at 14%. And Africa’s average national electrification rate of 43% <a href="http://www.worldenergyoutlook.org/resources/energydevelopment/energyaccessdatabase/">compares poorly</a> with 81% in developing countries in Asia and 98% recorded in Latin America. </p>
<p>The amount of capital required to close the infrastructure gap in Africa is estimated to be in the region of US$93 billion annually <a href="http://www.afdb.org/fileadmin/uploads/afdb/Documents/Publications/ECON%20Brief_Infrastructure%20Deficit%20and%20Opportunities%20in%20Africa_Vol%201%20Issue%202.pdf">until 2020</a>.</p>
<p>With China stepping in and funding economic infrastructure, as well as the establishment of the <a href="http://ndbbrics.org">BRICS Development Bank</a> and the <a href="http://www.aiib.org/html/aboutus/AIIB">Asia Infrastructure Investment Bank</a>, will the funding gap be filled? The answer is no. Africa needs to look to capital markets. </p>
<h2>What we know</h2>
<p>Sourcing funds for huge infrastructure development in Africa has always been fraught with difficulties. One major challenge is that the multilateral development finance institutions, which are dominated by the rich western countries, often impose stringent policy conditions to loans. It also appears that the funding required to close the infrastructure gaps is simply not available on the balance sheets of the World Bank and the African Development Bank. </p>
<p>Another issue is that the major lenders have historically been more active in financing social infrastructure such as health and education. Their approach to development in Africa has by and large been related to “poverty alleviation”. The critical role of economic infrastructure in spurring economic growth has not been accorded serious attention. </p>
<p>While social infrastructure is important for economic development, economic infrastructure is more urgent. Wealth creation and capital accumulation are facilitated more by investments in economic infrastructure. </p>
<p>The truth is that the old approach of countries relying heavily on multilateral and regional development finance institutions to fund infrastructure is unworkable. It is also incapable of closing the huge financing gap. In fact, neither the old nor the new institutions have the risk appetite for the kind of investments needed. If countries continue to rely on these organisations and institutions the pace for closing the infrastructure gap will be very slow. </p>
<h1>The way forward</h1>
<p>The point is that traditional development finance institutions are hesitant to provide resources for the huge but critical infrastructure investment required in Africa. </p>
<p>The emergence of the new multilateral development institutions is a welcome development. But they are in no way a panacea to current infrastructure financing challenges. The game-changing infrastructure projects that can make a dent in the infrastructure deficit and move economies to a higher growth path need to come from elsewhere. The place to start would be the time tested sources of long-term finance such as the debt market. </p>
<p>International capital markets provide a viable source of capital where, for instance, local debt markets are shallow or non-existent. Since 2007 more than ten African countries have raised considerable amounts from the international capital market in the form of <a href="http://www.euromoney.com/Article/3369170/African-Eurobonds-not-lucrative.html">Eurobonds</a>. </p>
<p>Traditionally, most African countries, with the exception of South Africa, have not seen the capital markets as a critical source of finance. One of the reasons countries didn’t float international bonds was because they didn’t have sovereign credit rating. But there are now 12 sub-Saharan Africa countries with ratings. Most have gone onto international capital markets to source <a href="http://www.euromoney.com/Article/3369170/African-Eurobonds-not-lucrative.html">funding</a>. Sadly, most countries are yet to get sovereign credit ratings, a prerequisite to accessing finance from international capital markets.</p>
<p>Yet raising debt financing in the capital market is probably one of the most potent sources of finance for rapid infrastructure development. This is because countries are able to raise funds for earmarked projects without policy conditionalities. And the cost of the funds, while relatively expensive compared with concessional loans from the World Bank and other multilateral development finance institutions, is often cheaper than loans from international banks. </p>
<p>Countries have to be encouraged to go to international capital markets to raise funds for projects. And these funds should not be used to finance consumption but should be channelled directly into the financing of much-needed economic infrastructure.</p>
<p>The railways and canals in America were largely financed with capital raised through bonds in the first half of the 19th Century. The American railways securities, as they were called, were financed from both domestic and foreign sources. </p>
<p>Since time immemorial huge infrastructure projects have been financed with funds from the capital market. This is because national budgets are often unable to support the required infrastructure expenditure. In other words, the balance sheets of states lack the fiscal space to accommodate the huge financial outlays required for infrastructure development. On the other hand project finance provides off-balance sheet resources that do not compromise the fiscal balance. </p>
<p>Any suggestion that traditional finance institutions or development finance institutions would be willing and able to fund the mega projects required in Africa is an illusion. Governments must turn to the market to raise capital.</p><img src="https://counter.theconversation.com/content/50782/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Matthew Kofi Ocran receives funding from the NRF. </span></em></p>Since time immemorial, huge infrastructure projects have been financed with funds from the capital markets. Africa should not rely on development finance institutions.Matthew Kofi Ocran, Professor of Economics, University of the Western CapeLicensed as Creative Commons – attribution, no derivatives.