The Political Economy of Sovereign Debt Restructuring in the Age of Sino-US Competition (2023)

Many low and lower-middle income countries are in financial distress or in default

A large number of low income and lower-middle income countries are experiencing financial distress in the wake of COVID-19, the Ukraine war and the U.S. interest rate shock. Some countries have already defaulted on their debt. Others are on the verge of doing so. 

Earlier this year, international rating agency Fitch said that nine governments had defaulted in 2020-23 compared to thirteen in 2000-19. In addition, Fitch currently rates eight sovereigns at CCC+ and another nine at B-, meaning another seventeen countries are at elevated to high risk of default. For reference, the cumulative five-year default probability of sovereigns rated into C-CCC range is 40%. The actual number of countries in distress and at high risk of default is however far higher, as Fitch does not rate all countries.

Markets take a similar view. The dollar debt of around two dozen countries is currently trading at more than a 1,000 basis, meaning that they are effectively shut out of international capital markets and at increasing risk of a default. But not all countries issue international bonds. Credit ratings and market-based distress measures therefore fail to capture the breadth of the financial challenges currently experienced by developing economies.

The IMF estimates that almost 60% of all low-income countries, or a total of more forty countries, are either in default or at high risk of financial distress. In addition to low-income countries and several lower-middle income countries are also in severe distress (Egypt, Pakistan, Tunisia) or are already in default (Ghana, Lebanon, Sri Lanka, Ukraine, Zambia). Even some upper-middle income countries are in deep distress or in default (Argentina, Russia). Financial instability challenges are concentrated in low- and lower-middle income economies, particularly in sub-Saharan Africa.

Any delay in providing financing assurances and debt relief has significant economic costs

Just as developing economies are experiencing peak financial distress, they are finding it harder to receive the financing assurances and the debt relief necessary to put in place IMF programs. This is leading to a further increase economic and financial costs in the context of prolonged distress and default. The lender-of-last-resort, the International Monetary Fund (IMF), will only extend loans to distressed and defaulted countries once it receives so-called financing assurances from a country’s creditors. 

But disagreement among creditors, particularly among the Paris Club and China, has led to significant delays to IMF rescue packages and debt restructurings. Increased creditor fragmentation prevents pre-emptive debt restructuring and leaves countries in distress and default for longer, thus preventing a timely return to economic and financial stability and imposing significant additional economic costs on distressed countries.

The uncertainty surrounding debt relief and restructuring has also has made debtor countries more reluctant to seek pre-emptive debt relief, which has led to an even greater build-up of financial imbalances. Moreover, the longer it takes to restructure the debt and attract new financing flows, the greater the economic costs to a country.

Sovereign debt restructuring has always been an ad hoc process

Admittedly, sovereign debt restructuring has always been an ad hoc process. And previous episodes of distress and default have not always been dealt with very efficiently. The prolonged economic crisis and financial malaise of many developing and emerging economies, particularly in Latin America in the 1980s is a case in point. Debt restructuring was pushed off for too long in the context of ultimately unsuccessful adjustment programs. The failure to restructure debt led to far greater economic pain and greater aggregate financial losses than if debtors and creditors had agreed to an early debt restructuring and economic adjustment. In Latin America, the 1980s are tellingly referred to as the lost decade. Economies were in near-continuous crisis and the macroeconomic adjustment programs had significant socio-economic costs, while ultimately failing to prevent a default.

In other words, dealing efficiently with financial distress and sovereign debt restructuring has never been easy. But things have deteriorated in the past few years, compared to the previous two decades. (There were exceptions, like Argentina in the mid-2000s.) Today debt restructuring has become more difficult. For example, it took two Zambia two years to receive the so-called financing assurances necessary for IMF financing to be unlocked. And it took another year for Zambia’s creditors to restructure its debt. And the debt restructuring deal currently on the table may not provide sufficient relief for Zambia to avoid future financial instability. Sri Lanka, which defaulted last year, is making better progress, but the process of providing debt relief has been far from efficient. 

For the longest time, economists were concerned that the emergence of bond rather than loan financing would undermine the prospect for efficient sovereign debt restructuring. Bondholders were thought to have greater incentives not to participate in a debt restructuring and instead to pursue their financial claims through legal avenues. By contrast, banks creditors were sees as having greater incentives to restructure the debt and find it easier to find to reach an agreement, amongst themselves and the debtor, not least due to the pressure they face from their respective governments. This is not to suggest that the emergence of private bondholders as often the dominant private-sector creditor does never create any obstacles. Argentina, for example, felt compelled to pay off hold-outs in 2016. But, in part thanks to collective action, which diminish the power of holdout creditors, they generally represent a manageable obstacle today.

Increased creditor fragmentation has further complicated the provision of debt relief

It turns out that it is the increased division, distrust and disagreement among bilateral creditors that represents a greater stumbling block to sovereign debt restructurings. In particular, China’s emergence as a major international creditor to low-income countries and its reluctance to abide by the traditional norms guiding sovereign debt restructuring accounts for the present problems. Unless traditional creditors, represented by the Paris Club, and China converge on a common set of principles, debt distress and debt restructurings will remain prolonged affairs. 

China has emerged as the largest bilateral creditors in recent years due to its extensive lending to low-income countries in the context of the Belt and Road Initiative. But Chinese lending is not the only reason for low-income countries’ over-borrowing. Ultra-low interest rates following the 2008 global financial crisis led private investors to provide significant financing to so-called “frontier economies”, effectively low-income countries with little experience of borrowing on international capital markets. However, private creditors represent much less of an obstacle to efficient debt restructuring than disagreement among bilateral creditors.

Initially, creditor cooperation looked likely. In early 2020, an agreement was reached on the so-called Debt Service Suspension Initiative (DSSI), which allowed eligible countries to suspend their external debt service in the context of the COVID-19 crisis. Shortly thereafter, a so-called G20 Common Framework was established with the aim of facilitating international debt restructuring for low-income countries by allowing Paris Club and non-Paris Club creditors to negotiate debt relief in a single committee. But only three countries, Chad, Ethiopia and Zambia, have applied for debt relief. And disagreement among creditors meant that creditors took a long time to provide debt relief. Zambia is a case in point and its experience sharply limits the incentives for other countries to apply for debt relief under the framework.

The IMF plays a critical role in delivering debt relief and economic adjustment

It is important to understand the role played by the IMF in the context of debt restructurings to understand why the provision of debt relief is not working properly. The IMF is a crucial player in case a country enters financial distress or falls into default. For a start, the IMF provides balance-of-payments financing conditional on economic adjustment, which is aimed at correcting imbalances and re-establishing macroeconomic stability. To this end, the IMF staff prepares a debt sustainability analysis with no input from creditors. The analysis establishes the so-called resource envelope and the required financial relief a country needs to seek from its creditors in case the debt sustainability analysis shows that the debt burden is unsustainable. The IMF program and IMF lending are conditional on the Fund receiving financing assurances from the country’s creditor.s Financing assurances are necessary for the economic adjustment to be successful and for the IMF to safeguard its financial resources.

The IMF itself is neutral in terms of how the costs of the debt relief are to be allocated to a country’s various creditors as long as the required debt reduction takes place. This is precisely why inter-creditor conflict is so prominent. Debt relief is a zero-sum game, and every creditor would like to minimize its losses and get others to provide debt relief. Historically, the problem of inter-creditor equity was managed reasonably well because the IMF was dominated by largely Western creditors, which were organized in the so-called Paris Club, a group coordinating the activities of the major bilateral creditors. In this context, the IMF received and accepted financing assurances from a “representative standing forum”, namely the 22 creditors of the Paris Club (and various observers and ad hoc members). In generally, this allowed the IMF then to approve a program and provide financing, typically a pre-requisite for other multilateral and private financing.

Six principles underpinned the Paris Club: solidarity, consensus, information sharing, case-by-case approach, conditionality (IMF program) and comparability of treatment (accept no less favorable a restructuring). The club-like character allowed creditors to coordinate their policies and ensure inter-creditor equity. The “comparability of treatment” principle also helped ensure an equitable allocation of financial losses between bilateral creditors and private-sector creditors. Coordination between the Paris Club and the IMF was also supported by the fact that the Fund’s major shareholders were members of the Paris Club.

Disagreement among bilateral creditors prevents IMF from supporting financially distressed countries

In principle, however, the Fund sticks to a non-toleration of arrears vis-a-vis official creditors, meaning that as long as a debtor country is in arrears on its debt to a bilateral creditor, the Fund cannot extend any credit to the debtor. Individual countries therefore effectively had a veto over IMF lending programs. The Fund accepted financing assurances from Paris Club members, often extended to non-Paris Club creditors as voiding arrears for the purpose of providing loans. But effectively, this gave individual Fund shareholders the right to veto an IMF program, therefore providing with enormous leverage, provided a debtor country was in arrears in its debt.

In 2015, a reform of the lending into arrears policies to official creditors (LIOA) in principle allowed the Fund to approve a program even if a country is in arrears, or has failed to receive financing assurances, form an individual shareholder, but only under specific circumstances: the official creditor consents and it does not jeopardize IMF financing. The reform sought to strengthen the incentives for collective action to provide for so-called official sector involvement (provision of debt relief by bilateral lenders) as long as the debtor was seen as engaging in good faith negotiations with its creditors. But given the importance of China as a bilateral creditor, the IMF under current rules is unlikely to approve an IMF program over China’s objections.

Effectively, China has a veto over the approval of an IMF program, and China needs to offer financing assurances for the IMF to be able to approve a program. By comparison, private creditors are in far weaker position, as the Fund allows for lending into arrears (LIA) to private creditors as long as debtor is negotiating with creditors in “good faith”. Private sector creditors do not have a veto over IMF programs. This policy was introduced in the late 1980s with the purpose of weakening private sector leverage which had allowed private sector creditors to block IMF lending indefinitely while nudging recalcitrant creditors to engage constructively with the debtor country.

Traditional bilateral creditors and China are struggling to find common ground

Sovereign debt restructuring has always been an ad hoc process, pitting creditors and debtors and creditors against creditors. The emergence of major non-Paris Club bilateral creditors, namely China, which does not accept the traditional Paris Club approach to restructuring, is undermining inter-creditor coordination and is complicating the swift provision of financing assurances and the efficient restructuring of sovereign. Not only has China the ability to block IMF programs. Its importance as a creditor, in many countries it is the most important bilateral creditors, means that without China agreeing to sufficient debt relief, lasting economic stabilization prove impossible, at least in the context of inter-creditor equity.

For example, across all DSSI countries, external debt owed to Paris Club feel to 11% in 2020 from 28% in 2006, while China ‘s share increased to form 2% to 18% and Eurobonds increased from 3% to 11%. Last but not least, debt owed to multilateral development banks fell form 55% to 48%. Under traditional rules, loans from MDBs loans are treated as preferential creditors whose debt is considered super-senior on account of its concessional character. If China did not participate in a restructuring, the Paris Club and private creditors would need to private disproportional debt relief, potentially making China whole.

Moreover, the West charges China with using secret clauses and opaque lending practices, including “hidden debts”. This also has Paris Club members concerned about inter-creditor equity. Western creditors will be reluctant to restructure their claims as long as they do not know how much the country owes to China and whether debt owed to China is restructured on (roughly) same terms as its own, or at all. Otherwise it risks incurring a disproportional share of the financial losses. China has indeed preferred to deal with debt problems on a bilateral basis, which has weakened multilateral creditor coordination. A lack of transparency and trust is main reason why financing assurances have been withheld and debt restructurings take so long.

China, on the other hand, objects to the super-seniority of multilateral loans, which effectively forces all other creditors to take greater losses, as their claims are traditionally excluded from restructuring. As China is underrepresented in multilateral institutions, it incurs a disproportional loss compared to Western creditors, given its relatively larger share of bilateral claims and its underrepresentation in multilateral development banks. China also objects to how the various types of lending should be classified for the purpose of debt restructuring. All of this has made the process of providing debt relief very choppy and unpredictable. Unless a coordinated approach to debt restructuring is agreed on, countries in distress and default will continue to suffer unduly against the backdrop of creditor fragmentation.

China wants to bend international norms to minimize its financial losses

China and other creditors stand next to no chance of getting repaid in full in many cases of sovereign debt distress. All creditors will have to take a loss. Inter-creditor conflict is about how the financial losses are allocated. As long as the conflict continues, providing debt relief quickly and efficiently along established or newly established lines will remain choppy.

Some observers have alleged that China is strategically withholding support for traditional debt restructuring because it wants to weaken the Western-dominated international financial architecture in the context of a Cold Financial War. This is why it prefers bilateral restructurings and disregards established multilateral norms. However, other China-dominated institutions like the Asian Infrastructure and Investment Bank (AIIB) are cooperating smoothly with established MDBs like World Bank along traditional lines. 

More likely, however, China simply seeks to minimize present and future financial losses. And China may not yet have come to accept the inevitability of losses. Certainly, individual creditors, perhaps for bureaucratic rather than grand-strategic reasons, are reluctant to acknowledge significant financial losses. China, for the most part, does behave like a commercial creditor keen to recover its money, which explains debt treatment and maturity extension rather than face value reductions and larger NPV reductions. China’s interest-free loans come out of aid budget and therefore do not lead to any financial losses in accounting terms. Bureaucratic interests and incentives may prevent a more sensible approach to debt restructuring that would benefit China and the debtor countries.

China will reluctantly, if incompletely accept the need for multilateral financial cooperation

There are good reasons to believe that China will largely, if reluctantly and incompletely come around. After all, as long as Western creditors do not allow China to free-ride, China’s bilateral restructuring approach will only go so far, as Beijing is unlikely to be able to impose adjustment policies on debtor countries. Moreover, providing refinancing to a sovereign that is essentially insolvent just leads to throwing good money after bad money and simply kicks the can down the road before it hits a wall. Then China faces the choice between greater cooperation with Western creditors or not getting its money back.

Nevertheless, as long as the Paris Club and Beijing cannot agree, future debt restructuring will not become smoother. China is in the end likely to come around, if reluctantly and gradually and incompletely, to accepting a sovereign debt restructuring debt template along traditional norms. The West will not bail out China. And China will not want to be blamed for holding up debt relief and economic stabilization in a situation where losses have become inevitable. 

But with financial losses inevitable and the political costs increasing, the incentives to converge largely if incompletely to the traditional debt restructuring template will strengthen relative to a scenario where recalcitrant Western creditors refuse to sign up to a restructuring that, from their point of view, unfairly advantages China. After all, few countries will be willing to end their financial relationship with Western creditors by choosing to treat China more favorably than Western creditors. In the meantime, it is countries in distress and default that will incur the cost of continued inter-creditor disagreement.

Monetary Policy and Debt Sustainability in Japan (2023)

The end of deflation in Japan?

While during the past year and a half the world’s major central banks have exited ultra-loose monetary policies to counter the post-COVID, Ukraine-war-related spike in inflation, the Bank of Japan has chosen to maintain a negative interest rate policy, making it an anomaly among large central banks. The reason behind this is that Japanese authorities are more worried about a return to deflation rather than what they view as temporary inflation. Nevertheless, the Bank of Japan has begun to adjust its policy framework to give it more flexibility to respond to inflation should it turn out to be persistent. Some economists and political analysts are worried that monetary tightening and higher interest rates may make Japan’s massive debt unsustainable and even constrain the Bank of Japan’s willingness and ability to raise interest rates. However, the risks are manageable and high government debt is very unlikely to make the Bank of Japan hesitant to raise interest rates to fight inflation, should this become necessary.

Since the bursting of the real estate and financial bubble more than thirty years ago, Japan has experienced very low inflation verging on deflation, which forced the Bank of Japan into adopting increasingly unorthodox monetary policies, including quantitative easing, qualitative easing, yield curve control and negative interest rates, in an attempt to support economic growth and prevent the economy from sliding into deflation. Once an economy falls into deflation, domestic spending may stall on the expectation of lower prices and asset price deflation helps increase the real value of liabilities, which weighs on investment and financial stability.

The post-COVID-19 spike in inflation globally and in Japan has delivered some reprieve from deflation and a debt-deflation spiral and has forced the Bank of Japan to reconsider its policies and broader monetary policy framework, originally devised to prevent deflation. Today, the bank is faced with elevated inflation, which has forced the Bank of Japan to gradually adjust its policy framework over the past year.

Inflation spiked to more than 4% in January, which is very high by Japanese standards. In August, Japanese headline and core inflation had fallen to 3.2% and 3.1%, respectively. The Bank of Japan has a mandate to maintain inflation at 2%. On its face, this would suggest that the Bank of Japan should abandon its unorthodox, ultra-loose monetary policy to bring down inflation. However, the government forecasts inflation to decline to 2.6% in fiscal year 2023 (which began in April) and 1.9% in 2024 against the backdrop of current policies. 

Current inflation dynamics raise the question whether the central bank needs to tighten monetary policy at all. The Bank of Japan is certainly to avoid repeating the mistake it made in 2006 when it raised interest rates too early and pushed the economy back into an economic slowdown and deflation. Governor Ueda has said the bank wants to see inflation reach 2% on a sustainable level. This suggests that the bank is worried about the economy sliding back into deflation once the post-COVID-19 and Ukraine-related energy price shocks abate. Tightening monetary policy today would then precipitate a slide back into deflation territory.

At the same time, however, the Bank of Japan wants to avoid triggering a financial shock and market instability in case high inflation persists and forces the bank to tighten monetary policy. In order to strengthen its credibility and commitment to fight deflation, the Bank of Japan adopted a rigid, constraining policy framework in the context of the deflationary pressures of the 2010s. In particular, it committed to capping long-term yields, effectively forcing it to buy as many government bonds as necessary to keep interest rates under the cap. If the bank were forced into removing this cap overnight to regain control of monetary policy to fight inflation, markets would likely have suffered a massive sell-off and high volatility. Many investors would have been caught off-guard. 

To that end, the bank has begun to make its policy and policy framework more flexible. It has begun to tweak its so-called yield curve control policy introduced in 2016 and widened the band around the zero-percent ten-year yield target from 0.25% to 0.5% in December. In July it announced that it would treat the upper and lower bound of the new interest rate corridor as references rather than rigid limits while establishing 1% as a cap, effectively allowing for a tightening of monetary policy as yields increased. In April 2023, it also announced that it was going to review its policy framework. All of this is meant to provide the Bank of Japan greater policy flexibility and prepare investors for a possible shift in policy.

The Bank of Japan is making a gradual shift towards a more flexible monetary policy framework so as to be able to tighten policies without causing financial market turmoil in case inflation fails to decline. However, to the extent that it makes its present policy framework more flexible, the shift towards a more flexible framework introduced some policy tightening. For example, widening the range around the zero target for ten-year bond yield has pushed up yields and translated into higher interest rates. So the authorities are walking a tightrope in terms of granting themselves greater flexibility and engaging in possibly unwanted monetary tightening.

Why a large government debt burden will not constrain monetary policy

Aside from risks related to rolling back its unorthodox monetary policy – unorthodox policy measures include quantitative and qualitative tightening, yield curve control and a negative policy rate – some analysts have expressed concern about what higher interest rates may do to government debt sustainability. These concerns are overblown in economic terms, which is why the level of government debt will not constrain the Bank of Japan in terms of tightening monetary policy if this is what is required to bring inflation under control. In economists’ speak, Japan does not suffer from fiscal dominance, whereby monetary policy is constrained by a high government debt for fear that higher interest rates may trigger a debt crisis.

The combination of high government debt and ultra-low, even negative interest rates has puzzled casual observers for a long time. High, potentially unsustainable government debt is supposed to translate into higher interest rates to compensate for the higher default risk. After the recent experience in other advanced economies, which saw sharp increases in debt levels coincide with ultra-low interest rates, Japan’s experience is not as unique anymore. However, Japan is the only country today that maintains a negative policy rate. At 260% of GDP, Japan has one of the highest government debt ratios in the world. However, if measured in net terms, government debt is around 160% of GDP, which is high but far less daunting than at 260% of GDP. 

More important than the level of debt is its cost. It is not the nominal interest rate, which may be influenced by monetary policy, but the real interest rate that determines its effective cost. If monetary policy translates into higher nominal interest rates, nominal debt service measured in yen will increase, but so will the nominal size of the economy. A better measure of the cost of debt is the real interest rate. From this perspective, Japanese interest rates were not all that low in real terms in the past two decades, as its economy teetered on the verge of deflation, while interest rates were more or less zero. This is also why deflation was such a concern to policymakers. Deflation increases the real debt burden and real interest rates. So even if the government paid zero interest rates on its debt, real interest rates were not necessarily negative, which contributes to adverse debt dynamics. 

The level of real interest rates affect debt dynamics, but they are not its sole determinant. Real economic growth and the primary fiscal balance (government revenue minus government expenditure, before interest) co-determine whether or not debt is sustainable, meaning whether the debt-to-GDP ratio increases, remains stable or declines in the long term. This is another way of saying that higher real interest rates do not necessarily undermine debt sustainability as long as real economic growth picks up, too. There is little reason to expect that real interest rates should significantly exceed the real growth rate of the Japanese economy. If economic growth falls, so should interest rates, and vice versa. This is why an increase in nominal interest rates in the context of higher inflation or higher economic growth will not fundamentally alter government debt dynamics.

There is one caveat, however. If the Bank of Japan were to proceed with significant quantitative tightening, meaning the sale of government bonds held by the bank, in the context of a need to increase long-term interest rates to keep a lid on inflation, the amount of interest-bearing debt held by the public would increase. At present, the Bank of Japan holds around 50% of all Japanese government bonds and bills, worth a little more than 100% of GDP. In a hypothetical scenario where the Bank of Japan reduces its balance sheet to the levels a decade ago, this would increase the amount of interest-bearing bonded debt to around 170-180% of GDP, up from 100% of GDP today. This could double the public sector’s debt service, all other things equal. However, such a massive balance sheet reduction would only happen in case inflation is persistently high, which in turn would help alleviate the debt burden. 

This is a long-winded way of saying that the broader outlook for debt sustainability hinges not only on nominal interest rates, but also on the combination of real interest rates, real economic growth and the government’s fiscal policy. Last but not least, the average maturity of the Japanese government bond(?) is about six years, meaning it would take time for higher real interest payments to affect long-term debt dynamics, which would give the government time to adjust its fiscal policy. For the moment, however, the Bank of Japan is unlikely to feel constrained in its monetary policy actions by the high government debt levels. 

A large net international creditor position provides an additional financial buffer

Moreover, Japan may have the highest government debt ratio in the world, but Japan is also the world’s largest international creditor in dollar terms, and a substantial net international creditor measured as a share of GDP. Unlike the United States, Japan does not rely on foreigners to finance its government deficit to a significant degree. Around 15% of Japanese government bonds are owned by foreigners. 

In fact, an increase in Japanese interest rates would provide Japanese investors incentives to repatriate their foreign assets, and it would provide incentives to foreigners to acquire Japanese government debt. Assuming that foreign investors are more fickle, Japanese investors have every reason to buy Japanese debt once interest rates increase. Effectively, overseas Japanese assets can be seen as providing an additional financial buffer. Moreover, and perhaps more importantly, Japanese government debt is denominated in Japanese yen. This further sharply curtails roll-over risk, as the central bank can always step in to absorb newly issued debt.

Japan continues to run sizable current account surpluses, fluctuating between 2% and 4% of GDP. Surpluses mean that Japan accumulates foreign assets and, all other things equal, its net creditor position strengthens and makes more foreign assets available for potential repatriation and the purchase of government debt. It is virtually impossible for a country with a large net foreign creditor position and large foreign surpluses to default. A strong international financial position makes it unlikely that the government would not be able to attract sufficient demand for its debt from Japanese residents.

Another way to look at this is that a current account surplus means that Japan continues to save more than it invests, and that it consumes less than it produces. Japan’s government debt burden is not a reflection of national financial profligacy. Rather, Japan's government debt burden is a reflection of inter-sectoral financial imbalances. Japan as a whole, the combined government and private sector, is financially on a sound footing. A high level of government debt reflects a high level of government dissaving, which is more than offset by an even higher level of private sector savings. 

Put differently, Japan generates sufficient savings domestically to finance government deficits. In principle, this means that the government could simply increase taxes rather than issue debt to the private sector. This makes it unlikely that domestic investors will balk at financing the government. Unless investors come to doubt the government’s political willingness to do so, they understand that economically the Japanese government can always raise taxes to ensure solvency.

Bank of Japan faces difficult balancing act in terms of inflation and deflation

The Bank of Japan will need to be cautious in terms of tightening too much, too early. With inflation declining in the United States and Europe, it does not look like that the recent inflation increase is structural or permanent. Of course, the Federal Reserve and the European Central Bank have increased rates very forcefully, but a case can be made that much of the decline in headline inflation has been due to the sharp decline in energy prices and the normalization of supply chains post-COVID-19. The next few months will provide further evidence in this regard. The Bank of Japan has in fact adopted a wait-and-see approach. It has insisted it needs further data on inflation to decide whether or not to change its monetary policy more forcefully.

The Bank of Japan faces a difficult balancing act. But it is unlikely to feel constrained by Japan’s large government debt burden or concerns about debt sustainability. The challenge the Bank of Japan faces is economic-technical rather than political. If the Bank of Japan reforms its policy framework too quickly by giving its greater policy flexibility, it may trigger policy tightening and expectations about further policy tightening that risk pushing the economy back into deflation. If the bank goes too slow and inflation remains persistently high, it may be forced into too rapid an adjustment of its policy framework, monetary policy and interest rates that risks rippling through domestic and even international capital markets. 

This is why the Bank of Japan will go as quickly as it must while going as slowly as it might to exit two decades of unorthodox and largely unprecedented monetary policies. The Bank of Japan will continue to move towards a more flexible monetary policy framework by abandoning both yield curve control and its commitment to a negative short-term policy rate, which would give it the flexibility to move away from quantitative easing, should this ever become necessary. The point is to reform the policy framework so that the Bank of Japan is in a position to deal with both inflation and deflation while limiting the risk that a precipitous policy shift upsets financial markets as well as the risk of increasing deflationary risk by making the framework less rigid. Governor Ueda and his colleagues will need to muster all their experience and skills and most of all sound judgment to navigate the Japanese economy through this challenging time.

H Worries about fiscal dominance and about government debt sustainability are overblown. And even if the Bank of Japan lifts interest rates, Japan will not necessarily be more constrained in terms of fiscal policy and resources, and it certainly will not face debt sustainability issues. If anything, higher interest rates might lead to a decline in asset values, which might cause financial stress, particularly in the financial sector, like what the United States experienced earlier this year. But this is another story. The government will face manageable financial difficulties.

So what?

If, contrary to the argument laid out here, Japan had a debt problem, it would face significant constraints. First, it would have to accept higher inflation, which all other things equal would prove unpopular, as it has done virtually everywhere else, and further undermine the ruling Liberal Democratic Party’s and Prime Minister Kishida’s popularity. And if higher interest rates were to risk putting Japanese government finances on an unsustainable path, Japan would find it more difficult to mobilize the financial resources to support defense spending. Lastly, if Japanese truly risked becoming unsustainable after the Bank of Japan exits unorthodox monetary policies, Japan might sooner or later suffer an economically and financially destabilizing debt crisis, which would weaken its international standing and credibility. Given the present dynamics in East Asia, this could also prove destabilizing geopolitically. As this column has argued, the concerns expressed by some analysts about what higher interest rates might do to Japan’s economic and financial stability and by extension to its geopolitical standing are not warranted.

Argentina - To Dollarize or Not to Dollarize? (2023)

Popular economic frustration has increased sharply in Argentina in recent years against the backdrop high and rising inflation. Argentina is faced with the prospect of hyperinflation and a renewed external default in the run-up to the first round of presidential election on October 22. Wide-spread frustration with the economic situation has led Javier Milei, a libertarian presidential candidate, to propose dollarization as a solution to Argentina’s economic problems. Dollarization would see the dollar replace the peso as the national currency. 

Argentina appears to be coming full circle. A little more than thirty years ago, Argentina under the Menem government established a so-called currency board, which closely tied the peso to the dollar and can be thought of as a lesser form of dollarization, only to abandon the regime in the wake of the 2002 financial default. Two decades later, one of the leading presidential candidate wants to get rid of the peso altogether and tie Argentina’s economic fortunes even more closely to the dollar than the currency board did. Is this a good idea?

Fixed-exchange rate regimes in emerging markets have gone out of fashion

Tempora mutantur. Three decades ago, fixed exchange rates were very popular among emerging economies. They provided a monetary anchor to establish and maintain domestic price stability and they kept the value of the currency stable vis-à-vis an anchor currency, typically the dollar, thereby facilitating international trade and cross-border capital flows. Fixed-exchange rate pegs or, in the case of Argentina, a currency board helped countries overcome high inflation and economic instability following the developing market debt crises of the eighties when many governments resorted to printing money to manage their financial problems.

Currency pegs have since gone out of fashion, at least among the top-tier emerging economies. Most Asian economies were forced off their pegs in the 1997 crisis. Mexico was pushed off its peg in 1994-95, Brazil in 1998-99, Russia in 1998. Today most major emerging economies have moved towards more flexible, if not necessarily completely flexible exchange rate arrangements. Oil-exporting Gulf countries and many small Caribbean island economies are an exception. Countries that abandoned their pegs managed to put in place sufficiently credible institutions, including independent central banks, that allow them to maintain price and general economic stability in the context of more flexible exchange rates. A more the flexible exchange rate regime affords policymakers greater macroeconomic flexibility. 

Dollarization constrains macroeconomic flexibility

Under a fixed exchange rate system, a country largely foregoes control over monetary and exchange rate policy. A fixed exchange rate means that policymakers are obligated to do what is necessary to maintain the external value of the currency against an anchor currency. Unless controls limit capital in- and outflows, domestic interest rates need to be changed in lockstep with the interest rates of the country to whose currency the local currency is pegged. If the domestic interest rate is lower than in the anchor country, capital outflows will lead to a loss of foreign-exchange reserves and ultimately currency devaluation. A fixed exchange rate under conditions of an open capital account sharply constrains central bank monetary policy. Effectively, short-term interest rates are set by the Federal Reserve if the currency is pegged to the dollar.

In this case, the relative lack of control over domestic interest rates and the exchange rate means that fiscal policy needs to be even more flexible. If, for example, a country suffers an exogenous shock, as Argentina did in the late nineties following Brazil’s currency devaluation and the deterioration of its terms-of-trade (the ratio of export to imports prices), economic growth slows. Unable to cut interest rates or devalue the currency, an expansionary fiscal policy can help support the economy. But if fiscal space, the ability to run an expansionary fiscal policy, is limited due to a high debt burden, the economy will run below potential, at least temporarily. In fact, if public debt is high and investors worry that low growth and inappropriately high interest rates lead to a rapid increase in government debt, a country may be forced to pursue a restrictive fiscal policy instead of an expansionary policy, leading to a further slowing of economic activity. 

Dollarization creates financial vulnerabilities

Besides constraining macroeconomic flexibility and the ability to respond to exogenous shocks, dollarization, even more so than other types of fixed exchange rate regimes, creates potential financial vulnerabilities. If a government already has high debt, the risk of a loss of investor confidence and a debt crisis is greater, given the unavailability of monetary and exchange rate policy to increase growth and reduce debt payments by way of a weaker exchange rate and lower interest rates . This risk is even higher under full dollarization because the central bank only has a limited amount of dollars to address liquidity crisis in case investors are reluctant to finance the government. 

The “harder” the currency regime, the more fiscal policy flexibility needs to be preserved. This can be very difficult to do, politically,. Full dollarization may increases the susceptibility to debt crises, particularly in the absence of a highly disciplined fiscal policy. A loss of investor confidence can and does occur in dollarized regimes, jeopardizing government debt sustainability of the financial and the stability of the financial system. If history is anything to go by, Argentina will find it difficult to conduct such a forward-looking, disciplined fiscal policy.

Moreover, a country loses seigniorage under full dollarization. Seigniorage refers to the income that is generated through currency issuance. Denying the government seigniorage is, of course, is a big part of the rationale for dollarizing the economy in the first place, namely to remove policymakers’ incentive and ability to generate extra revenue by way of higher inflation. In addition to the ongoing loss of seigniorage, dollarization also generates significant one-off costs related to the acquisition of the dollars necessary to dollarize the economy. You may call this negative seigniorage because it involves repurchasing previously issued currency. 

Finally, dollarization sharply curtails the central bank’s ability to act as a lender-of-last resort. Under dollarization, the central bank cannot “print” money or offer unlimited amounts of liquidity. Only the Fed can. This increases liquidity and hence default risk in terms of sovereign debt and the banking sector. Even if the central bank requires banks to hold a liquidity reserve, the fact that there is a limit to how much the central bank can lend to the sovereign or the banking sector during a crisis will increase the risk of a financial crisis turning systemic. Not being able to print domestic currency may lead to stable inflation, but it can also limit the ability of the government to deal with financial crises. Under a fixed exchange rate regime, the country would be forced off the currency peg if it provides liquidity. In a dollarized regime, the government and the banking sector will be forced into default in the event of a severe financial shock. 

Argentina’s trade structure is not conducive to successful dollarization

Dollarization makes more sense, if it makes sense at all, for countries that are highly integrated in terms of international trade and financial flows, particularly with the economy whose currency they adopt. (This is why creating a common currency in Europe made or more sense.) If a large share of trade is conducted with dollar-based economies, a fixed exchange rate can help improve access to their markets by creating exchange rate stability. 

Less than 10% of Argentine exports go to the United States. (Argentina exports more to Brazil and China.) If the dollar appreciates by 30% against all other currencies, Argentina’s exports will become less competitive. If 90% of Argentina’s export went to the United States, a sharp dollar depreciation would have only a minimal impact on Argentina’s export revenues. And Argentina is also vulnerable to large terms-of-trade shocks given that 2/3 of its exports consist of agricultural products, not counting other commodities like energy or metals.

Moreover, if an economy has a large traded sector and suffers a negative terms-of-trade shock, only small price changes are needed to increase export revenues (so-called internal devaluation). But Argentina is a very closed economy, and it conducts very little trade with the United States. Argentina is one of the most closed economies in the world with trade accounting for only 1/3 of GDP. This puts Argentina at 169 out 179 countries for which data are available. 

Operational challenges

Operationally, Argentina would need to acquire sufficient dollars to dollarize its economy. But the government is a net foreign-currency debtor as well as a net international debtor. It does not have enough dollar assets to finance dollar purchase. The government just repaid the IMF in yuan rather than dollars. Even the central bank, typically a net foreign-currency creditors, sits on a negative net dollar position. Argentina is also on the verge of yet another default, which would make it even more impossible (if anything can be more impossible than impossible) to borrow the dollars required to replace the peso. Finally, a recent ruling by a New York court that awarded $16 billion worth of damages to a plaintiff to compensate it for financial losses incurred in the context of Argentina’s expropriation of YPF a decade ago will further complicate Argentina’s attempt to raise dollars, whether it defaults or not in the coming months. 

Nationalizing private-sector dollar assets would be politically extremely controversial and it might be legally impossible. It may also not help Argentina make dollar purchases. Few foreign investors would be prepared to enter a transaction where such assets are pledged as collateral or where they would be expected to purchase them outright, given that they would become subject to litigation. In short, it is not clear where Argentina would find the dollars to dollarize its economy. 

Some commentators have highlighted the risk of a bank run and a broader financial crisis that dollarization would trigger. It should also be pointed out that the Ecuadorian president who decreed dollarization was ousted within a couple of weeks of his decision. So regardless of the economic-financial effects of a conversion, political risk would increase independently. In addition, a banking crisis might be triggered if depositors were to withdraw their deposits in order to try to convert them into dollars. Such a scenario could be avoided, though, if the authorities impose a bank holiday. But this may not happen if the new government commits to dollarization before entering office. 

On the other hand, depositors who withdraw their deposits will find that the black market exchange rate has already adjusted in anticipation of dollarization. They may then quickly come to the realization that keeping their funds in interest-bearing bank deposits is preferable than moving them from their money under their mattresses, particularly given very high inflation. But only because depositors may not be able to purchase the dollars after emptying their bank accounts does not mean that the banking sector could come under severe liquidity pressure, unless the government steps in forcefully. 

The very weakness dollarization is meant to eliminate will make it challenging to maintain the regime

Plenty of risks attach to dollarization, particularly in Argentina. But how have other countries managed to dollarize their economies and achieve low inflation. In Latin America, Panama adopted the dollar in 1904, Ecuador in 2000, and El Salvador in 2001. Panama has arguably been the most successful of the three, even though it did on occasion experience exogenous shocks and financial instability. But it has managed to maintain dollarization, low inflation and fair levels of economic growth. After more than two decades of dollarization, neither Ecuador nor El Salvador have experienced an economic or financial meltdown. However, both countries are on the verge of a sovereign default. In fact, Ecuador restructured its debt with China in 2022. Argentina is more likely to follow the path of Ecuador and El Salvador rather than of Panama.

Two out of the three cases tend to lend support to the hypothesis laid out above. For dollarization to work, governments need to run disciplined fiscal policies and create ample of space to respond to economic and financial shocks. If they cannot do this, dollarization will lead to a build-up of financial vulnerabilities, financial instability and sovereign default. And a default in a dollarized regime is extremely messy, economically and politically, as banks are typically government creditors, forcing banks to write their debtors, including depositors.

What Argentina’s political history tells us about the sustainability of dollarization

Argentina’s economic and political history gives little reason for optimism that full dollarization will be sustainable in the longer term. Argentina has defaulted more than a dozen times in its history and experienced hyperinflation. It even managed to default on its IMF loans and may do so again shortly. Unless Argentina manages to fundamentally reform its politics and maybe political system, it is unlikely to be able to muster the economic discipline necessary to maintain dollarization. Distributional conflict is too high or the government is too weak to maintain economic discipline, or both.

Dollarization is not a panacea and comes with significant risks. Full dollarization will only prove sustainable if policymakers pursue fiscally responsible policies. But dollarization is being promoted precisely because the government cannot maintain macroeconomic discipline. Leaving aside operational-political issues, such as whether a new president has the ability to push through large spending cuts, particularly if s/he does not have sufficient congressional majorities, maintaining long-term discipline is crucial for the system to deliver both low inflation and financial stability. If Argentina dollarizes, its economy and financial fate will continue to hinge on the government’s ability and willingness to act in a financially responsible way. Otherwise dollarization will go the way of the currency board more than two decades ago.

Argentina would be better off reforming its economic regime along the lines of some of its neighbors, such as Chile, Colombia or Peru. These countries have independent central banks and they pursue fairly disciplined fiscal policies. This allows them to operate fairly flexible exchange rate regimes and conduct more independent interest rate policies capable of absorbing exogenous shocks. Similar to Argentina, both Chile and Peru are highly susceptible to terms-of-trade shocks on account of their commodity-heavy export structure. Commodity prices fluctuate much more than the prices of manufacturing goods. 

A comparison with Brazil’s economic policy regime suggests that a somewhat (sic!) less disciplined fiscal policy can be compatible with reasonably levels of inflation as long as the central bank is independent. (In all fairness, Brazil benefits from a low level of foreign-currency debt, making it easier for policymakers to let the exchange rate float and target inflation.) If Argentina managed to put in place such a regime, there would be no need to run the greater financial instability risks that come with dollarization. In this sense, full dollarization is a second-best solution to the inflation and economic instability problem. It is also a solution that is fraught with very substantial risks. Such a regime would limit the monetary policy discretion and translate into lower inflation. But as long as the government is unable to conduct a disciplined fiscal policy, dollarization will not really represent a sustainable solution to Argentina’s long-standing economic problems.