National Solvency and the Special Case of the US Dollar
In recent blog posts we’ve been looking at sovereign government issues of bonds. We have argued that this is not really a “borrowing” operation but rather bond issues offer a (higher) interest-earning alternative than do reserve deposits at the central bank. We also have argued that it makes little practical difference whether the government bonds are held domestically or by foreigners.
However, it is true that in a floating currency regime, it is conceivable that foreigners who hold reserves or government bonds could decide to “run” out of them, impacting the exchange rate. By the same token, countries that want to run net exports with, say, the US, are interested in accumulating Dollar claims—often because their domestic demand is too low to absorb potential output and often because they want to peg their currencies to the Dollar. For that reason, a “run” is unlikely.
This then leads to the objection that the US is surely a special case. Yes, it can run budget deficits that help to fuel current account deficits without worry about government or national insolvency precisely because the rest of the world wants Dollars. But surely that cannot be true of any other nation. Today, the US Dollar is the international reserve currency—making the US special. Let us examine this argument.
Isn’t the US special? Yes and no. Accounting identities are identities; they are true for all nations. If a nation runs a current account deficit, by identity there must be a demand for its assets (real or financial) by someone with foreign currency. (A foreigner could either demand the nation’s currency for “direct investment” that includes buying property or plant and equipment, or the foreigner could demand financial assets denominated in that currency.) If that demand for assets declines, then the current account deficit must also decline.
There is little doubt that US dollar-denominated assets are highly desirable around the globe; to a lesser degree, the financial assets denominated in UK Pounds, Japanese Yen, European Euros, and Canadian and Australian dollars are also highly desired. This makes it easier for these nations to run current account deficits by issuing domestic-currency-denominated liabilities. They are thus “special”.
Many developing nations will not find a foreign demand for their domestic currency liabilities. Indeed, some nations could be so constrained that they must issue liabilities denominated in one of these more highly desired currencies in order to import. This can lead to many problems and constraints—for example, once such a nation has issued debt denominated in a foreign currency, it must earn or borrow foreign currency to service that debt. These problems are important and not easily resolved.
If there is no foreign demand for IOUs (government currency or bonds, as well as private financial assets) issued in the currency of a developing nation, then its foreign trade becomes something close to barter: it can obtain foreign produce only to the extent that it can sell something abroad. This could include domestic real assets (real capital or real estate) or, more likely, produced goods and services (perhaps commodities, for example). It could either run a balanced current account (in which case revenues from its exports are available to finance its imports) or its current account deficit could be matched by foreign direct investment.
Alternatively, it can issue foreign currency denominated debt to finance a current account deficit. The problem with that option is that the nation must then generate revenues in the foreign currency in order to service that debt. This is possible if today’s imports allow the country to increase its productive capacity to the point that it can export more in the future—servicing the debt out of foreign currency earned on net exports. However, if such a nation runs a continuous current account deficit without enhancing its ability to export, it will almost certainly run into debt service problems.
The US, of course, does run a persistent trade deficit. This is somewhat offset by a positive flow of net profits and interest (US investments abroad earn more than foreign investments in the US). But the two main reasons why the US can run persistent current account deficits are: a) virtually all its foreign-held debt is in Dollars; and b) external demand for Dollar-denominated assets is high—for a variety of reasons.
The first of these implies that servicing the debt is done in Dollars—easier for indebted American households, firms, and governments to obtain. The second implies that foreigners are willing to export to the US to obtain Dollar-denominated assets, meaning that a trade deficit is sustainable so long as the rest of the world wants Dollar assets.
What about government that “borrows” in foreign currency? What about nations that issue foreign currency denominated assets? Returning to a nation that does issue debt denominated in a foreign currency, what happens if the debtors cannot obtain the foreign currency they need to service the debt?
We have thus far left to the side questions about who is typically issuing foreign currency denominated debt. If it is a firm or household, then failure to earn the foreign currency needed to service the debt can lead to default and bankruptcy. This would be handled in the courts (typically, when debt is issued it is subject to the jurisdiction of a particular court) and by itself poses no insurmountable problem. If the debt is too large, bankruptcy results and the debt must be written-off.
Sometimes, however, governments intervene to protect domestic debtors by taking over the debts. (Ireland is a good example.) Alternatively, governments sometimes issue foreign currency debt directly. In either case, default by government on foreign currency debt is usually more difficult—both because bankruptcy by sovereign government is a legally problematic issue and because sovereign default is a politically charged issue.
In practice, sovereign default (especially on foreign currency debt) is not uncommon, often chosen as the lower cost alternative to continuing to service debt. Sovereign governments typically choose when to default—they almost always could have continued to service debt (for example, by imposing austerity to increase exports, or by turning to international lenders). Apparently, they decide that the benefits of default outweigh the costs. However, this can lead to political repercussions. Still, history is littered with government defaults on foreign currency debt.
Governments sometimes issue foreign currency debt on the belief that this will lower borrowing costs—since interest rates in, say, the US Dollar, are lower than those in the domestic currency. However, foreign currency debt carries default risk—and if markets price that into interest rates, there may be no advantage. Still, it is not uncommon for governments to try to play the interest differentials, issuing debt in a foreign currency that has a lower interest rate. Unfortunately, this can be a mirage—markets recognise the higher default risk in foreign currency, eliminating any advantage.
Further, as discussed in earlier blog posts, for a sovereign government, the domestic interest rate (at least the short term interest rate in the domestic money of account) is a policy variable. If the government is spending domestically in its own currency, it can choose to leave reserves in the banking system or it can offer bonds. In other words, it does not have to pay high domestic interest rates if it does not want to, for it can instead let banks hold low (or zero) interest rate reserves. This option is available to any currency issuing government—so long as its spending is domestic.
As discussed earlier, government will be limited to purchasing what is for sale in its currency—and if it is constrained in its ability to impose and collect taxes then the domestic demand for its currency will be similarly limited. So we do not want to imply that government spending is not constrained—even in a sovereign country that issues its own currency.
But if a national government issues foreign currency denominated IOUs, the interest rate it pays is “market determined” in the sense that markets will take the base interest rate in the foreign currency and add a mark-up to take care of the risk of default on the foreign currency obligations. It is likely that the borrowing costs in foreign currency will turn out to be higher than what government would pay in its own currency to get domestic (and foreign) holders to accept the government’s IOUs.
This is usually not understood because the domestic currency interest rate on government debt is a policy variable—usually set by the central bank—but policy makers believe they must raise domestic rising interest rates when the budget deficit rises. This is done to fight inflation pressures or downward pressure on exchange rates that policy-makers believe to follow on from budget deficits. In truth—as discussed above—if a country tries to peg its exchange rate, then a budget deficit could put pressure on the exchange rate. So there is some justification for attempting to counteract budget deficits with tighter monetary policy (higher domestic interest rates).
But the point is that government sets the domestic interest rate on overnight funds, which then closely governs the interest rate on short-term government bonds. So if government wants lower rates on its debt, it can always use domestic monetary policy to achieve that goal. Unfortunately, this is not widely understood—hence—governments issue foreign currency denominated debt and then take on risk of default because they actually must get hold of foreign currency to service the debt. Thus, it is almost always a mistake for government to issue foreign currency bonds.
Conclusion on US exceptionality. So, yes, the US (and other developed nations to varying degrees) is special, but all is not hopeless for the nations that are “less special”. To the extent that the domestic population must pay taxes in the government’s currency, the government will be able to spend its own currency into circulation. And where the foreign demand for domestic currency assets is limited, there still is the possibility of nongovernment borrowing in foreign currency to promote economic development that will increase the ability to export.
There is also the possibility of international aid in the form of foreign currency. Many developing nations also receive foreign currency through remittances (workers in foreign countries sending foreign currency home). And, finally, foreign direct investment provides an additional source of foreign currency.
Next week we will turn to impacts of government policy in an open economy: trade deficits and exchange rate effects.
This article first appeared at New Economic Perspectives.