Sovereign Borrowing Essay

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Sovereign borrowing is the process whereby a government raises debt finance, either on the capital markets or through borrowing from commercial banks. In general, the basic principles of borrowing are applied, but the specifics of the situation are given by the fact that the borrower is the government and/or a public entity that is considered to be owned or close to the government. The very traditional model would state that the borrower in the case of sovereign borrowing must be the government (the “state” in continental European parlance), and it cannot be derived for any other public entity, regardless of the fact that the (central) government would implicitly or explicitly guarantee for the entity. However, more recent internationally promoted documents widen the concept of “sovereign” (see, for instance, the text of the Basel II Agreement, where for bank risk purposes, the sovereign has been fairly widely defined). Here, we will primarily endorse the classical interpretation of sovereign borrowing, where only the central government may be regarded as (real) sovereign, while others may have derived sovereign status, primarily for risk management and risk assessment purposes.

Modern governments generally run deficits. In and before the 19th century, a good minister of finance was one who could provide a surplus in the government coffers; the beginning of the 20th century brought the fashion of a balanced budget; and finally, after World War II, and especially since the 1960s, deficits in public finances have become chronic, and the situation is unlikely to change anytime soon. At present, the U.S. federal government is the largest sovereign borrower, running its public debt to the amount of $9.5 trillion in early 2008. In fact, all major Organisation for Economic Co-operation and Development (OECD) countries are running public debts, which represent a significant part of gross domestic product (GDP). Sovereign borrowing (public borrowing) is not only the consequence of increased (or ever increasing) public spending per se, but also (as theory states) contributes to smoothing national consumption, or to undertaking projects that could not have been financed without externally raised finance.

Repayment

Sovereign borrowing raises the question of whether the holder of power is capable of servicing the debt or, in the case of being unable to serve it due to liquidity problems, is ready to address the problems and is willing to adhere to the internationally set arbitration committees. The issue of willingness to pay has attracted the attention of scholars. In a more traditional legal sense, the sovereign power may do whatever it pleases on territory that is under its control. However, from the very early 20th century, the absoluteness of the rights has been challenged, although more in private than in public law. Today, there are even legal theories that call for the support of more inherent rights and the intervention of sovereign powers (foreign governments) and international organizations, if the sovereign power in the case infringes the principles of international law (and/or principles of “natural law”).

Economists are generally more prone to assume that even a government can be declared bankrupt, but usually they avoid considering the problem of enforcement. Creditors usually cannot seize the assets of the debtors, at least not on the territories where the debtor is a sovereign power. Assets may be seized if on the territories of other countries, but even then, enforcement costs may be higher than expected. Often, the local courts may refuse to look into the case, or the political factor may be as strong as the country where the claim is made and would not like to see the relationship with the debtor deteriorated. In practice, it may be only the U.S. courts that would consider the claim for repayment, if one is to base the judgment on the practice of “attracted jurisdiction” that the U.S. courts have exercised in the last decade or so.

Economic theory has offered two explanations as to why sovereign debtors (i.e., governments) repay their debt. One explanation revolves around the reputation theory, that is, that the government pays when the obligation is due to preserve a good reputation, and have the access to credit in the future. In other words, keeping a good credit rating is a crucial motivational factor, as it should provide easier access to finance internationally. The other explanation focuses more on possible sanctions. Although the sanction may not be a result of domestic court proceedings, the threat of sanctions, primarily by other governments, may serve as a motivational factor. Sanctions, usually trade related, can motivate, especially small open market economies. Most likely, the combination of both influences sovereign borrowers to follow the letter of contract and repay the debt. Even in cases where governments announced a moratorium on servicing foreign debt, they reversed their decisions fairly quickly, but not before there was damage to their reputation and credit rating internationally.

The theory of sovereign borrowing states that open economies, with significant inflows of foreign direct investments (FDIs), should have better access to international financial markets. However, more recent research has shown that, surprisingly, this may not be the case. It seems that reputation factors are the most important when granting funds to a particular sovereign borrower. The most important factors, not surprisingly, are those related to long-term stability, both economic and political, and prospects of the sovereign borrower. Often, international capital (debt) markets are very good at assessing the trends in economic performance of a particular country, and the loss of confidence in the borrower’s abilities to meet the claims is an important signaling device in lending modeling.

The importance of sovereign borrowing is expected to increase, as public sector deficits are growing and need to be served in a way that will not destabilize national economies (i.e., through the monetization of the public deficit).

Bibliography:

  1. Eduardo Borensztein et al., Sovereign Debt Structure for Crisis Prevention (International Monetary Fund, 2005);
  2. Inter-American Development Bank, Living with Debt: How to Limit the Risks of Sovereign Finance (Harvard University Press, 2006);
  3. Chris Jochnick and Fraser A. Preston, Sovereign Debt at the Crossroads: Challenges and Proposals for Resolving the Third World Debt Crisis (Oxford University Press, 2006);
  4. Lex Rieffel, Restructuring Sovereign Debt: The Case for Ad Hoc Machinery (Brookings Institution Press, 2003).

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