Perplexing Sovereign Debt to GDP Ratio:

between 237% Japan (April, 2017) and 59% Argentina (2018), which is more risky?

Today, Japan is far more indebted than Argentina.

‘Gross Sovereign Debt to GDP ratio (Gross SD/GDP Ratio)’ is a measure to compare the level of sovereign government debts among different peers. In this measure, Japan has the world top position of 237% as of April 2017 (Chart 2); and Argentina has 56% in 2018 (Chart 1).

If the government debt to GDP ratio is a metric to measure the credibility of a government’s fiscal and monetary management, Japan.gov must be far less credible than Argentina.gov.

On the other hand, the credit ratings of their sovereign bonds cast a totally different story. While Japan’s government bonds (JGB) possesses an investment grade rating — rated A1 by Moody’s (December, 2014), A+ by S&P (April, 2018), and A by Fitch (April, 2017) — Argentina’s government bond (AGB) has a speculative/non-investment grade rating — rated B2 by Moody’s (November, 2018), B+ by S&P (August, 2018), and B by Fitch (May, 2018).

The more you borrowed, the better credit rating you get.

Isn’t it perplexing?

If you are not perplexed, here are two very natural questions:

1. Why does Japan have a better credit rating than Argentina? The more heavily indebted peer, Japan, has a better rating than Argentina. In a way, the more you borrow, the better credit rating you get! Why is that?
2. Can Japan pay back the sovereign debt, given at the world top record level of 236% of its GDP (April, 2017)? In other words, is Japan solvent?

Simply put, this counter-intuitive relationship between ‘Gross Sovereign Debt to GDP Ratio (SD/GDP Ratio)’ and ‘credit rating’ is shaped primarily, if not the only, by the difference in the proportion of foreign-currency denominated external debts between these two countries.

On one hand, most of, if not all, JGBs (Japan’s Government Bonds) are denominated in its own local currency, JPY (Japanese Yen). On the other, a significant portion of AGB (Argentine government bonds) are denominated in foreign currencies, predominantly in USD (Chart 3). This difference becomes critical for Argentina at times of the maturities of existing debts (the repayment of existing debts to their creditors). Argentina has to earn USD in order to repay its USD-denominated external debts. That would deprive Argentina of its sovereign independence over fiscal and monetary policies.

This content focuses on this primary driver, the denomination of sovereign external debts, that divides the fate of sovereign debts between these two countries.

Here, in order to put them into a perspective of credit rating, let’s contemplate a stress test situation to examine their insolvency risk. Now, we assume a crisis situation under the following two assumptions:

• Crisis Assumption 1) both parties are in fiscal deficit and have to refinance in order to repay their existing debts;
• Crisis Assumption 2) there is no willing-investors to purchase their newly issued debts.

Under this hopeless situation, what can they do?

As of today for Japan — whether it works forever is a different question to be discussed later — it is a matter of issuing its own currency to service its outstanding sovereign debt, simply because its debts are denominated in its own currency. This is called ‘monetization’ of sovereign debt. The monetized portion of its debt does not necessarily need to be repaid (to be explained later). Thus, it is not a compulsory liability in a strict sense. In this sense, Japan appears to have no insolvency risk. Is that so simple? Can Japan increase its debt indefinitely through monetization? This would be discussed later.

On the other, given the same crisis conditions, Argentina, in order to pay back the portion of its USD denominated external debts, needs to earn USD. In other words, if Argentinian currency (ARS) depreciates materially, the local currency value of the Argentinian external debts explodes. Thus, for the case of Argentina, the sovereign debt management would involve currency risk: solvency risk and currency risk become the two sides of the same coin in Argentine sovereign debt management.

For the case of Japan, currency risk has no material involvement in the repayment process of sovereign debt: since the portion of foreign currency denominated external debts is small. This difference in the proportion of foreign-currency denominated external debts can result in a critical difference in solvency dynamics.

Despite the fact that this difference is not the only factor that differentiates these two countries, it is a critical difference that divides the fates of these two countries in the architecture of their sovereign debt management. Keeping this notion in mind, let’s compare the economic dynamics of these two countries’ sovereign debt management, one by one. Now, we start with Argentina.

Argentina

Repeatedly, our question is: while Japan’s government’s ‘Gross Sovereign Debt to GDP Ratio’ (SD/GDP Ratio) is more than double Argentina’s one (Chart 1), why would Japan deserve a better credit rating than Argentina?

As stated earlier, a significant portion, around 70 %, of AGB (Argentine’s government bonds) is denominated in foreign currencies (Chart 3), predominantly in USD. That exposes Argentine sovereign debt management materially to currency exchange risk. As a result, the government of Argentina has an intense political priority on currency stability — although they fail. That deprives Argentina of its sovereign independence over fiscal and monetary policies, by imposing on the country extra constraints that Japan does not face. Although there might be multiple ways to slice the unfavorable dynamics, I would like to portray it in a framework of the ‘Strained Triangle’ illustrated in Figure 1: the presence of foreign-currency denominated sovereign debts constrains three objectives: sovereign debt management; full sovereign discretion in fiscal policy; and full sovereign discretion in monetary policy. (Caution: This is different from the famous ‘Mundell-Fleming Impossible Trinity.’)

Currency risk is embedded in foreign-denominated external debt management

Now, we will examine how the currency exchange risk is directly embedded in ‘foreign currency denominated external debt management’ for Argentine case.

To start with, among three vertices of the Strained Triangle in Figure 1, let’s focus on the top of the triangle — foreign currency denominated sovereign debt management — to see how currency depreciation constrains the sovereign debt management in the local currency term:

1. Legacy transaction(s):

• Due to currency depreciation, the repayment value would exceed the borrowed money in the local currency term. In other words, Argentina has to pay more than it borrowed. (Negative)
• Due to currency depreciation, the value of its outstanding USD-denominated debt will increase in local currency term. A heavier burden going forward. (Negative)

2. Current transaction: At the time of repayment, the Argentine government has to either use its currency reserve or obtain USD from the market.

• As its currency reserve declines, there would likely be a speculative attack on ARS. (Negative)
• If the government has to acquire USD from the market, it needs to issue its local currency first then exchange it to USD. The transaction itself will impose a further downward pressure on its own currency and increase inflationary pressure on the domestic economy. (Negative)

In either case, the repayment would be negative for the exchange rate. (Negative)

Obviously, these dynamics arising from foreign-currency denominated debt affect its own local currency denominated sovereign debt management as well. Thus, for Argentina, its sovereign debt management and currency management are two sides of the same coin. And the repayment transaction would be negative for the currency exchange rate, holding other conditions constant.

Now, let’s move to the interaction among the three vertices of the triangle.

Sovereign Discretion of Fiscal Policy:

Now, let’s focus on the sovereign discretion on fiscal policy. ‘The Crisis assumption 1’ above supposes that Argentina has fiscal deficit: in other words, Argentina maintains its own sovereign discretion to expand fiscal spending. It would raise concerns among the debtholders, especially investors of foreign currency denominated AGB. It could trigger a negative chain reaction:

1. First, it could induce the debtholders to sell their holding collectively: risk spread widening (negative);
2. then, such a move is likely to induce speculative moves on the currency. (negative);
3. in addition, it would compel locals to exchange their peso saving into USD via black markets for the sake of wealth preservation. (negative)

Overall, it would result in the depreciation of Argentinean Peso (ARS). The depreciation of ARS is unfavourable to the sovereign debt management for Argentina, as stated earlier. In the context of foreign-currency denominated sovereign debt management, Argentine government cannot have a full sovereign discretion over its fiscal policy: it might be compelled to impose an austerity to sacrifice basic subsidies that is a life line for a low-income class under the poverty line. Or, if Argentine government maintains its full sovereign discretion in expanding fiscal spending, it would compromise its foreign-currency denominated sovereign debt management. Thus, these two objectives cannot be met simultaneously. Argentina has to sacrifice either of the two objectives: credible sovereign debt management; sovereign discretion on fiscal policy.

Sovereign Discretion on Monetary Policy:

How about the sovereign discretion on monetary policy? It would depend on the effect of its USD denominated debt management on inflation rate. As stated earlier, at the maturities of existing foreign-currency denominated sovereign debts, the assumption 2 contemplates that there is no investor to purchase a newly issued bond. Thus, the government would have to monetize to repay the debt. That would increase the portion of local-currency denominated sovereign debts. The repayment of its USD denominated debt by itself, requiring USD, is unfavourable to ARS, with other conditions constant. Its implication — the impairment in the purchasing power of the local currency — would induce local residents to sell ARS in exchange for USD. Furthermore, speculators would reinforce the momentum of currency depreciation. If the selling force goes beyond the level of its USD holding in the foreign currency reserve, the government would fail to stabilize the exchange rate.

The resulting depreciation of the local currency must be positive for export, despite negative for import. But, is it?

1. Importers:

• Argentina is a capital goods importer. A higher price for capital goods import is negative for the domestic productions in both industrial and agricultural sectors. Uncompetitive domestic producers would not hesitate to increase their mark-up as well as to pass any increase in the cost to their customers.
• In addition, in the absence of hedging instruments, Argentina suffers from increasing import prices. (This also differentiates Argentina from Japan, where currency depreciation would not necessarily influence domestic prices of import products partly because there are hedging instruments available to both export producers and importers.)
• An acute depreciation in currency could make it difficult to pass the cost to customers. As a result, production can plunge. In addition, if there presents a high level of inflation, there would not be any credit available for leasing or financing. This will damage imported capital goods sales to export producers.

2. Exporters:

• Exporters would sacrifice domestic supply in order to earn better currency abroad. Thus, domestic prices of export products tend to be influenced by international prices which is denominated in USD.
• In the case of an acute currency depreciation, as stated earlier in the import section, the production of Argentina export products will be negatively affected due to increases in the cost of finance arising from the rising interest rate as well as the rising cost of capital goods for production in the local currency term. As an example, recent deterioration in ARS (as of 2018) actually destroyed credit available for the agricultural producers and reduced the sales of agricultural capital goods by 35%. (Bertello, 2018) As a result, the rising interest rates and the increased cost of imports stagnated the volume of export productions. Thus, Argentine export volume is expected to decline. (as of 2018)

A simplistic adjustment mechanism — an automatic trade-off between the changes in importers’ and exporters’ revenues due to a change in the exchange rate — would unlikely work for Argentina. Overall, currency depreciation could be ‘stagflationary’ — a synthetic term of ‘economic stagnation’ and ‘inflation’ — for Argentine domestic economy.

If the government tightens monetary policy in the middle of fiscal deficit, the economy would further slowdown. In this stagflationary setting, its monetary policy and fiscal policy face a dilemma. In addition, it could lead to a selling of AGB and an increase in the yields of AGB, the cost of funding for sovereign finance. It also would be negative to the currency exchange rate.

Overall implication:

Overall, three objectives — credible sovereign debt management, sovereign discretion on fiscal policy, and sovereign discretion on monetary policy — are impossible to be satisfied at the same time.

Contagious Triangle:

The problem could go beyond the impossibility of meeting the three objectives together at the same time. When Argentina sacrifices or fails one objective to a significant extent, the negative effect would transmit into the management of the other two objectives. Thus, ‘Strained Triangle’ becomes ‘Contagious Triangle.’ (Figure 2)

If the country fails to manage inflation to a significant extent, it would lead to the depreciation of the local currency; which would impair the sovereign debt management. Also, the currency depreciation itself, as stated earlier, is inflationary. These two factors reinforce each other and create a vicious cycle. Overall, the resulting negative prospect would induce capital drain out of the country. And the shortage of capital would be negative for the economic growth, thus, call for fiscal expansion. It shapes a full vicious contagious circle.

If it fails to manage fiscal imbalance to a significant extent, it would directly breach a credible sovereign debt management, by increasing debt. This would raise concern among investors and lead to the depreciation of local currency, which would be inflationary as stated earlier. While speculators attack ARS, locals also sell ARS in exchange for USD in black markets in order to preserve their wealth. Simply put, a collapse in the public confidence in the local currency would exacerbate inflation. It becomes a matter of time for the government to make its political decision to reschedule its debt service. Should they default, it would cause a catastrophic depreciation/devaluation of ARS, thus, further exacerbate inflation and cause a economic and political panic.

When any of the objectives on the vertices of the triangle fails to a significant extent, it could trigger a negative contagious chain reaction in the triangle.

This contagious scenario is a key risk in the presence of foreign currency denominated external sovereign debt.

The following charts — currency exchange rate (Chart 4), current account (Chart 5) as well as net trade (Chart 6), and the level of its sovereign debt (Chart 1) — reveal that after 2013 (framed in red dotted boxes) Argentina has progressively suffered from ‘Strained Triangle.’

These four measures have been progressively deteriorating since the current president, Mauricio Macri, came into the office in December 2015.

Unfortunately, we do not have reliable inflation statistics of this country since the government manipulated the official release of the statistics in the past. (Economist, 2011: Economist, 2012) Instead of inflation rate, we have Argentine policy rate in Chart 7 below.

Since April 2018, the central bank has been hiking again its policy rate in order to contain the rising inflation rate. The rising policy rate together with these deteriorating four measures above suggest that now Argentina entered into ‘Contagious Triangle’ in 2018.

Japan

How about Japan?

Why would Japan deserve an investment grade rating even at 236% (April, 2017) of Gross Sovereign Debt per GDP Ratio? What makes Japan different from Argentina? Is the portion of foreign-currency denominated external debts only the difference between them?

In hindsight, Japan has already begun its monetization of sovereign debts quite aggressively. Chart 2 shows the evolution of Japan’s debt monetization since 2013. In 2016, Japan’s cumulative monetization reached 33% of its total government debt, which is equivalent of 77% of its GDP. In other words, the government’s compulsory liability to other parties (excluding its central bank) is 160% (237% — 77%).

Monetization, inflationary by its design:

Monetization is inflationary by design. Let’s see the process of monetization step by step.

• Step 1) the government issues a new debt in order to pay back its existing debts;
• Step 2) on behalf of the government, the central bank issues currency in order to buy the newly issued debt;
• Step 3) once the government receives the proceeding it uses the currency to repay the debts to the creditors;
• Step 4) the currency either circulates into the economy or is saved in bank deposits;

In reality, today, these transactions can be further simplified by electronic ledger entries.

Simply put, a monetization process makes the central bank the creditor of the monetized portion of the sovereign debt — needless to say, the government is the debtor. In this way, a crisis time could compromise the central bank’s theoretical ‘political independence’. So we can treat the central bank as a part of the government in a loose term. In other words, the monetized portion of its debt would not need to be repaid ultimately, simply because the government cannot default on itself.

The government of Japan has already demonstrated to the world that “debt monetization” could be a way to service existing debt liabilities owed to other parties (excluding its central bank) — call them collectively ‘investors’. In this sense, Japan has no immediate insolvency risk as of today (2018). If there is no immediate insolvency risk, investors might not feel any immediate necessity to sell JGB collectively.

Inflationary Monetization and its Long-term Implication

Is that so easy? Can Japan continue monetizing its debt and reduce its debt effortlessly?

Here is an obvious risk that monetization can cause, inflation.

Monetization by design only injects new currency into the system, but does not absorb the same amount of currency out of the system since the newly issued debt is not bought by investors in exchange for money in its process. Therefore, its net effect is more money in the system, therefore, only inflationary. If the resulting inflation goes out of expectation and control, it would raise a concern since inflation impairs the purchasing power of money.

The recent Venezuela’s story that its annual inflation hits 488,865 percent in September reminds us that an extreme inflation can destroy the public confidence in its own currency and trigger a variety of economic and political catastrophes. (Ellsworth, 2018) It could suggest us: should inflation that Japan’s sovereign debt management accounts for go beyond its control, it could destroy the public confidence in JPY. And it is manifested not only by inflation rates but also by the deterioration in currency exchange rate. This should remind us of the triangle we saw in the case of Argentina. For Japan’s case, thanks to a negligible portion of foreign-denominated sovereign debts, the top vertex of the triangle in Figure 2 would simply represent the currency risk.

So far, Japan, just coming out of its deflationary pressure, there is no immediate concern on material inflation risk arising from the current monetization activity (as of 2018). Thus, it might be hard to imagine what inflation implication monetization can account for.

Now, in order to put it in a perspective, let’s contemplate implications of an extreme inflationary situation.

1. Uncontrollable inflation materially beyond the long term target level itself is an evil. (Negative)
2. Inflation would reduce the real value of the legacy debt since it is denominated in the local currency: that would be positive from the perspective of solvency, as long as its legacy debts are concerned. (Positive)
3. Inflation would increase the cost of funding toward the future. Future issuance of debt would become increasingly costly and difficult. (Negative)
4. An acute decline in the purchasing power of money would make it difficult for Japan to issue its sovereign debt in its own currency to attract domestic investors as well as foreign investors; (Negative)
5. Whether Japan can extend debt monetization, which is inflationary by design, would depend on the existing level of inflation. If inflation goes out of control, sooner or later a political decision might be made to default on or reschedule the outstanding government debt. (Negative)

The second item above suggests that inflation does present a favourable impact on Japan by reducing the real value of its debt. On the contrary, for the case of Argentina, inflation only presents negative impacts on its debts due to the presence of foreign-currency denominated debts.

Nevertheless, the overall effect of an extreme inflation could ruin the public confidence in its local currency, thus, it would be negative for Japan’s entire economy. Also causing a spike in the future funding cost, an extreme inflation would be a real threat to Japan’s sovereign debt management. Its future funding could be at risk. And there is no guarantee that Japan would not experience an extreme inflation in the future.

Long-term Implication: Uncharted Risk on the Horizon

As a matter of fact, Chart 8 illustrates the historical level of monetary base (in the blue line). And it reveals an explosion of monetary base as a by-product of quantitative easing (QE). Here, banks’ reserves at the central bank constitutes about 68% of monetary base in July 2018. In principle, the total banks’ reserve level sets the upper potential limit of the private sector’s lending activity through the mechanism of the Fractional Reserve Banking System. In other words, the current potential upper limit of lending is set at a historically high level. Nevertheless, so far, the private sector’s lending activity, measured by ‘M2/Monetary Base’ of the grey line of the chart, has declined dramatically since the bursting of its bubble in the 90s. That is why lending is not active and inflation as well as the economic growth has been low.

Nevertheless, once the lending activity picks up, lending can expand up to the theoretical potential upper limit. It could shoot up inflation to an unprecedented level. Of course, such an extreme scenario does not necessarily need to happen.

No one knows for sure whether this risk would materialize or not. Especially, history proves that QE did not work well in boosting lending (Suginoo, 2018). We do not know how our future economic conditions would unfold in relation to the level of monetary base, especially banks’ reserve.

All that said, the level of monetary base in Chart 8 presents an uncharted risk in our unknown future on the horizon (as of 2018).

Deflation: Strategic implication of Deflation for Government Debt Monetisation:

How about deflation? How could deflation interact with monetization?

• Deflation would obviously increase the real value of its legacy debt. (Negative)
• On the other hand, the cost of funding would be cheaper for a new debt. (Positive)
• Monetization would not have a material impact on inflation. (Positive)

In this sense, deflation is a favourable condition for debt monetization. At least, as long as inflation is contained within an expected low range, debt monetization would not cause a panic collapse of the public confidence in the local currency.

Thus, a strategic implication would be that Japan should accelerate its debt monetization to reduce actual/compulsory liabilities as much as possible while inflation expectation remains low. In this way, Japan could reduce its government debt without causing a collapse of the public confidence in JPY.

In addition, to reduce inflation risk, it would be imperative for Japan to reduce monetary base as soon as possible. Monetary policy, primarily focusing on supply side of the private sector’s lending activity, has been proven ineffective in restoring Japan’s economic stagnation, which is caused by its impaired demand. What needs to be addressed is not supply side problem, but demand side one. Thus, it is fiscal policy, not monetary policy, which is necessary to stimulate the demand and restore Japan’s economy. So, Japan would need to reduce its ineffective as well as unnecessary monetary base to a normalized level ASAP so that it can reduce the risk of future inflation and optimize its fiscal policy effect.

Other Implications:

Of course, the backdrop of debt monetization is Japan’s chronic fiscal deficit which was the flip-side of its low unemployment rate. A chronic fiscal deficit can account for other negative implications than inflation: as an example, structural imbalances that would inhibit innovation from taking over the old legacy systems. Japan needs to assess the long term implication over its chronic fiscal deficit.

Before too late, the government has to avoid a material collapse of the public confidence in the local currency. Sooner or later, the country would need to settle itself somewhere between a creative destruction for progress and full-employment via its chronic fiscal deficit.

Big Picture:

The portion of foreign-currency-denominated external sovereign debts, although it is not the only driver that divides economic dynamics between Japan and Argentina, is a critical difference in the construct of their sovereign debt management dynamics. Together with given distinct monetary conditions, this factor deprives Argentina of its sovereignty over fiscal and monetary policies. In a way, Argentina, by issuing foreign-currency denominated sovereign debt, has abandoned its sovereign independence to manage its fiscal and monetary policy.

While Japan has so far enjoyed its sovereign discretion over fiscal and monetary policies thanks to its negligible portion of ‘foreign-currency denominated external debt,’ there is no guarantee that its rating would remain with an investment grade in the future. Should it ruin the public confidence in its own currency, it has to face future funding problem. Although there is certainly such risk present on the horizon, there is no prognosis of its materialization yet (as of 2018). For the time being, its debt monetization can conveniently service its legacy debt.

REFERENCES

• Bertello, F. (2018, 10 17). Se desploman ventas produccion maquinaria agricola y temen por el empleo. Retrieved from https://www.lanacion.com.ar: https://www.lanacion.com.ar/2182705-se-desploman-ventas-produccion-maquinaria-agricola-temen
• Ellsworth, B. (2018, 10 9). Venezuela’s annual inflation hits 488,865 percent in September: congress. Retrieved from https://www.reuters.com/: https://www.reuters.com/article/us-venezuela-economy/venezuelas-annual-inflation-hits-488865-percent-in-september-congress-idUSKCN1MI1Y6
• Suginoo, M. (2018, 9 16). Enter the Monetary Wonderland, Part 2: Cycle of Paradox: Diminishing Effectiveness of Monetary Policy. Retrieved from www.monetarywonderland.com: https://www.monetarywonderland.com/cycle-of-paradox.html#2nd
• The Economist. (2011, 4 20). Argentina’s economy: lies and Argentine’s statistics. Retrieved from The Economist: https://www.economist.com/the-americas/2011/04/20/lies-and-argentine-statistics
• The Economist. (2012, 2 25). Argentina’s inflation problem: the price of cooking the books. Retrieved from The Economist: https://www.economist.com/the-americas/2012/02/25/the-price-of-cooking-the-books