When a government needs money to fund its operations, it can raise cash by issuing debt in its own currency. And if a government encounters difficulty repaying the bonds upon their maturity dates, it can simply print more money. While this solution has merit, on the downside, it will likely decrease the values of the local currency, which can ultimately harm investors. After all, if a bondholder earns 5% interest on a bond, but the currency’s value drops 10% due to inflation, that investor net loses money in real terms. For this reason, countries may decide to issue debt in a foreign currency, thereby quelling investor fears of currency devaluation eroding their earnings.
- When governments need money to fund their operations, they may issue debt in their own currencies, but if they struggle to pay off the bonds, they can print more money. This can cause inflation, which ultimately erodes investors' earnings potential.
- As an alternative to issuing debt in its own currency, a government may issue debt in a foreign currency to calm investor fears of currency devaluation eroding their earnings.
- Issuing debt in a foreign currency exposes a nation to exchange rate risk because if their local currency drops in value, paying down international debt becomes costlier.
- To evaluate a foreign nation's default risk, investors and analysts may evaluate a country's debt-to-GDP ratios, economic growth prospects, political risks, and other factors.
While issuing foreign debt may protect against inflation, borrowing in a foreign currency exposes governments to exchange rate risks, because if their local currencies drop in value, paying down international debt becomes considerably more expensive. This challenge, which some economists refer to as “original sin,” came to a head in the late 1980s and early 1990s, when several developing economies experienced a weakening of their local currencies and consequently struggled to service their foreign-denominated debt. During that era, most emerging countries pegged their currency to the U.S. dollar. Since then, many have transitioned to a floating exchange rate to help mitigate risk.
Government bonds issued in a foreign currency tend to draw high levels of scrutiny from investors seeking to evaluate the potential for a nation to default on its bonds, where a country would be unable to pay investors back. After all, there are no international bankruptcy courts where creditors can recover assets, leaving them little recourse if a country defaults. Of course, there are compelling reasons for a country to make good on its obligations. Chief among them: failure to pay bondholders can ruin its credit rating, making it difficult to borrow in the future. And if a nation's own citizens hold much of the national debt, defaulting can render government leaders vulnerable at election time.
Evaluating Default Risk
Telegraphing potential defaults is difficult, but not impossible. Investors frequently rely on debt-to-GDP ratios, which examine a country’s borrowing level relative to the size of its economy. But this metric doesn't always correctly predict defaults. For example, Mexico and Brazil defaulted in the 1980s when their debt represented 50% of GDP, while Japan has kept its financial commitments despite carrying a roughly 200% debt level in recent years. Consequently, it's prudent to take cues from credit rating agencies like Moody’s and Standard & Poor's, who evaluate a multitude of factors when grading the debt of sovereign governments around the globe. Case in point: in addition to looking at the country’s total debt burden, these agencies additionally assess economic growth prospects, political risks, and other metrics. Some economists also advise looking at a nation’s debt-to-exports ratio, because export sales provide a natural hedge against exchange rate risk.
The Bottom Line
Sovereign debt represents roughly 40% of all bonds worldwide, making it an important part of many portfolios. But it’s vitally important to understand the potential risks before deciding to invest.
After Argentina famously defaulted on its government debt beginning in 2001, it took several years for the nation to regain its financial footing. Venezuela, Ecuador, and Jamaica likewise recently defaulted on their debts, albeit for shorter periods of time.