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