Sovereign Defaults in a Globalized Financial System

Neither Russian businesses nor government economic regulators have learned how to extract positive results from Russia’s involvement in globalization. Instead, Russian business leaders and analysts view globalization as a threat, or at best a challenge, but never an opportunity.

The term “default,” which had previously been used only in a purely financial context, has become a buzz word in the media in the past three years. Discussions about the excessive sovereign debts of some countries and the inability of EU members to service them, as well as the possibility of a U.S. technical default on its sovereign debt, continued throughout 2010 and in 2011.

The term was widely used in Russia ten years ago, when the country painfully experienced the bankruptcy of its government. In 1997-1999, several countries in East Asia, as well as Russia and Argentina, defaulted on their government debts, which underscored the internal economic and external economic aspects of the problem. The first wave of the crisis on the Russian financial market was only the echo of the shocks that were happening worldwide.

In recent years, sovereign defaults have been taking place in countries where their national structures and financial and budget institutions are less developed than the corresponding structures of the international organizations that they have to deal with. Governments are pushed to the brink of bankruptcy by the crisis, because they failed to achieve the necessary level of national development before the crisis became acute, yet they still borrowed widely at the international level.

The example of Russia shows that the placement of debt obligations on the market of ruble-denominated instruments, formally making its debt entirely domestic, did not provide much help. While they were trying to make the ruble freely convertible, global investment institutions devised more sophisticated methods to interact with Russian banks in order to ensure their participation in investment in Russia’s sovereign debt.

Russian legislation did not prohibit the use of financial schemes to invest the money of non-residents in state treasury bills. They did this willingly, because the profitability of investment in government securities was extremely high. The full liberalization of non-residents’ investment in T-bills was undesirable in Russia, because a rapid inflow or outflow of large funds can destabilize a country’s finances. However, the limitations which the Russian government introduced contradicted the IMF statutes, so ultimately the parties agreed that these limitations be lifted.

In the first six months of 1997, foreign capital continued to flow into the Russian financial market even though the country's budget stability had been weakened. The government was struggling to make ends meet without borrowing more money, and the burden of debt servicing proved unbearable for the budget. It was a full-blown debt crisis. The government’s inability to pay its debts was the root cause of the 1998 crisis.

Maintaining stability under these circumstances was out of the question. The government had no option other than to admit that it could not honor its commitments on sovereign debt servicing in full and on time, which it did on August 17, 1998.

Ten years after that default, the fire of a new financial crisis swept across the globe in 2007 and 2008. By that time, the world had split into several groups: (1) countries with a balance in their deficit payments; (2) countries with a budget deficit; (3) countries with surplus balance in their payments; and (4) countries with a budget surplus. Countries with a double deficit had become the largest international borrowers before the crisis, while countries with a double surplus became creditors. Double deficit countries such as the United States, Britain, Italy, Spain and Australia became debtors.

There were three main causes of the imbalances and challenges in the global financial system: first, profound gaps between the competitiveness and effectiveness of national financial systems; second, the fact that the infrastructure of global markets was technically and legally far better developed than the ability of the subjects (transaction participants or market operators) to assess the risks of transactions involving different financial instruments; and third, the fact that imbalances and financial bubbles on the global markets appeared because there were no methods and no institutions for their global (international) regulation, while existing national regulations were clearly ineffective.

The financial system was the epicenter of the global economic crisis of 2007-2009. As with a catastrophic earthquake, several waves of dramatic fluctuations on the financial markets and in financial institutions could be expected – and they eventually happened. The latest of these are the sovereign debt crises in the United States and the euro zone countries. These crises were not unexpected for investors; banking systems prepare in advance for drops in the value of government bonds, and create relevant provisions for these losses. Bond holders develop plans to restructure the debts of the weakest issuers, such as the Greek government.

The protracted crisis in Greece reflects not only the structural economic weakness of Greece and comparable South European economies, but also the instability of the entire structure of the euro zone , which unites countries possessing different levels of economic efficiency. A hard currency with a stable exchange rate against the U.S. dollar, the euro does not prevent German exporters, or a number of Northern and Central Europe countries, from becoming more competitive by enhancing the productivity of their fixed assets and human capital. But the Greek economy has collapsed because of the impossibility to devalue the euro. In essence, the Greek government has already defaulted on its debt, but this was presented as a restructuring of its obligations, and a new stage of assistance from EU authorities and private holders of Greek securities.

So what happens next? It takes some time for the capital market and the foreign exchange market to adapt. Banks that hold Greek government bonds are putting up reserves against these “junk” assets. Investment funds, banks and private investors are converting their capital into cash or “safe haven” financial instruments: collateralized commodity obligations (CCOs), stable currencies such as the Swiss Franc or Japanese Yen, and, ironically, U.S. treasury bonds.

Thus, the market seems to have largely recovered from the Greek market news. The short-term consequences of the crisis in the euro zone have been successfully mitigated. However, in the medium term, perhaps after the debate over the U.S. debt ceiling is over, professional players in the stock market will return to the issue of the sovereign debt of Spain, Italy, Ireland and Portugal.

The economic problems of Russia's near and distant neighbors promise to bring it face to face with certain difficult challenges in the near future. Russia can no longer ignore the fact that the key consumers of its oil, gas and metals are slowing down. Although the purchase price of oil and gas may increase, the volume of acquisitions is sure to stagnate or decline. For Russia’s economy, crises in the euro or dollar zones are equally bad, because any increase in investment risks in one of these zones automatically increases the estimated investment risks in an emerging economy like Russia.

Russia’s banking system and financial markets are not strong enough to service the national economy as it crawls out of recession. Major corporations and banks regularly have to borrow on foreign markets. Companies are largely inefficient and fail to use their fixed assets and financial resources efficiently. Labor productivity is low in industry and services alike, both public and private: it is around 30% of labor productivity levels in the United States.

At this stage, neither Russian businesses nor government economic regulators have learned how to extract positive results from Russia’s involvement in globalization. Instead, Russian business leaders and analysts view globalization as a threat, or at best a challenge, but never an opportunity.

Since most transactions on the global financial market take place in U.S. dollars and often involve U.S. financial institutions, the U.S. government effectively dictates the global rules of the game, through its bank regulation and financial market reorganization policies.

Developed countries are facing two major threats. One is their fragile recovery from the crisis, with persisting high levels of unemployment. The other is a possible financial panic and a loss of confidence in certain monetary assets, flights away from certain currencies, financial instruments and institutions. While developing their policies aimed at “consolidating recovery,” leaders of developed economies have to make a difficult choice in their priorities: whether to stimulate economic growth and employment, or boost confidence in the national currency and thus to the national financial system.

For the next five to seven years, the global economy will most likely face inflation, slowdown or stagnation. In a sense, this will be the direct aftermath of the economic turmoil of the previous years.

The expansion of the dollar, euro and pound supply, which is often referred to by the politically correct term, QE (quantitative easing), has already caused growth in the dollar-based prices of all internationally traded commodity instruments, as well as an obvious acceleration of internal price increases in the euro zone countries.

The global economic situation is clearly doing little to encourage growth of the Russian economy. Although oil has shown a steady post-crisis growth, from a low of $40/bbl to today's level of $100 and higher, the increase in the prices of energy resources is not accompanied by an increase in demand. At the same time, imports are growing at the breakneck rate of 40% per year. Therefore, oil and gas exports are no longer stimulating economic growth, and instead are beginning to function more as a resource for simply maintaining the payment balance.

Russia’s economy has continued to depend on volatile oil prices. If they fall, Russia may be facing dark times. The surplus in Russia’s current account will be replaced with a deficit, followed by a weakening of the ruble. The federal budget deficit will increase sharply, while banks and large corporations will have problems with servicing their corporate debt.

In the next few years, economic growth in Russia will be largely defined by domestic developments. In fact there is an impressive list of encouraging factors that could provide a new spark to GDP growth in Russia: from a stable low-deficit budget (about 3.9% of the GDP in 2010) to resumed growth of Russian banks’ lending to non-financial sectors.

Investment activity was modest in 2010 and 2011. Analysts agree that the investment climate in Russia is still not good enough to make it a desirable destination for private investors, even considering the continued financial turmoil in the euro zone and the growing U.S. debt. The problem is that Russia’s main rivals for attracting capital are China, India and Brazil rather than Europe and the United States. In this context, Russia’s shortcomings as an investment destination become even more pronounced.

Views expressed are of individual Members and Contributors, rather than the Club's, unless explicitly stated otherwise.