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Lending to the state is far from risk-free

Lending to the state is far from risk-free

More than 90 countries have defaulted on their debt in the last two centuries, and in many instances they have been repeat offenders, according to a 2002 IMF commentary. Portugal has defaulted four times on its external debt obligations, while the country presently in the eye of the default storm, Greece, has defaulted five times.

The largest sovereign default in history, the default on Argentina’s US$100 billion debt, happened less than 10 years ago in 2002.  Preceding Argentina, Russia’s $73 billion default caused severe drops in financial markets and had a domino effect on the global economy.  

The most recent sovereign default by a rated country was Ecuador in 2008, on $3.2 billion of its debt obligations. However, this was for moral reasons, stating that its previous debt offerings were illegal and illegitimate.

Iceland remains in a financial crisis due to the collapse of three of its major commercial banks — which, relative to the size of its economy, is the largest banking failure in history.

Government debt is money owed by a government, often in the form of bonds, bills and notes, but may also include future liabilities such as pension payments, social benefits and unpaid contracted goods and services.

Sovereign debt is debt issued by a government denominated in a foreign currency, rather than the domestic currency in which government bonds are issued. When issuing sovereign debt, a strong and stable currency with investor demand is chosen, normally US dollars, euro or pound sterling. Investing in sovereign debt involves risks. Country risk is the risk associated with investing in a country, which includes economic risk, political risk, exchange-rate risk and transfer risk.

While all are equally important, exchange-rate risk concerns investors, as a significant currency devaluation would adversely impact the issuers ability repay the foreign currency in which the bonds were issued. Transfer risk applies when the government does not allow the currency to move out of the country.

A sovereign default manifests when the issuing country fails to make repayment on its debt obligations. But under the controversial legal doctrine of sovereign immunity, sovereign countries are not subject to normal bankruptcy laws, cannot be forced to repay and the lenders cannot seize the assets of the sovereign. Therefore a sovereign has the potential to escape responsibility for debts without legal consequences.

In most cases, debt may be rescheduled, interest rates possibly lowered, and the potential for a haircut or a reduction of the amount owed.  In extreme situations, the debt maybe outright repudiated or forgave.

A country will generally do everything possible to avoid a sovereign default as the capacity to borrow in the future will be greatly restrained, borrowing costs are likely to skyrocket, investors will be very hesitant to invest in the country and many will disinvest, the currency is likely to devalue, and a local, if not global economic crisis is probable.

The lessons and consequences of past sovereign defaults are the very reason why European and global leaders are presently working around the clock to avoid a repeat default by Greece.

Anthony Galliano is chief executive of Cambodian Investment Management.  [email protected]


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