The opinions expressed in this article are the sole responsibility of the authors and should not be interpreted as reflecting the views of Sveriges Riksbank.

The Covid19 pandemic has brought a joint health and economic crisis of vast proportions all over the world. It has forced governments around the world to increase spending to support the economies hit by the pandemic and by the measures to contain its spread. This increase in government spending is mostly financed through public debt issuance. Hence, the issue of government debt sustainability is back at the top of the economic policy agenda, especially for emerging and developing countries. In order to reduce their debt burden, countries may be tempted to revert to policies that lead to "financial repression" (see Reinhart and Sbrancia, 2015, for a definition), as mentioned in Tirole (2020) and Krueger (2020). Financial repression can keep the cost of domestic debt service artificially low. [1] This would not be the first time that the domestic sovereign debt burden in developing and emerging economies is reduced through financial repression, as shown in Reinhart and Sbrancia (2015). Although the use of policies that lead to financial repression may seem controversial, Chari et al. (2020) provide an economic rationale for the case of domestic debt repayment. The sustainability of external government debt in emerging and developing economies, though, concerns policymakers and academics to a larger extent. In this case, the implications of financial repression are nontrivial. This column discusses the interlink between domestic and external debt sustainability in the presence of financial repression, modelled in Di Casola and Sichlimiris (2017).

Mechanism

Our model features a small open economy, whose government issues domestic and external debt in response to aggregate shocks and can default on each type of debt. The domestic financial market is underdeveloped, meaning that domestic savers (bondholders) face a scarcity of private savings instruments - a characteristic of many emerging and developing economies. By using capital controls, an opportunistic government can restrict the access of domestic savers to the international financial market. In this way, the government directs the domestic savers’ demand for assets towards domestic debt, leading to financial repression. The interest rate on domestic debt can be kept artificially lower than the one prevailing in the international financial market. The difference between the domestic and the international financial market is that the government can affect the equilibrium interest rates in the former, but not in the latter. Hence, the interest rate on domestic debt is more sensitive to the amount of debt issued than it is the case for external debt. As a consequence, the government taps the international financial market for funds, so as to balance the benefits and costs of financial repression. In case of default, the government loses temporarily access to segmented debt market. Hence, the default risk connects the two types of debt.

Figure 1 reports the average ratios of domestic and external sovereign debt over GDP for a large sample of developing and emerging economies during the period 1970-2010, in the data and the model. Through the lens of our model, in less developed economies with more severe scarcity of private savings instruments, the government can sell domestic domestic debt at a lower rate. However, this also implies that the interest rate on domestic debt is more sensitive to the amount of domestic debt issued, giving rise to a larger share of external debt.

There are many other mechanisms offered in the literature to explain the sustainability of sovereign debt (literature overview in D’Erasmo et al., 2016). What distinguishes our work is that we can account for the level and composition of sovereign debt of emerging and developing economies, while being in line with the evidence on average negative real interest rates on sovereign debt (Escolano et al., 2016).

Conclusions

Following the large debt issuance due to the Covid19 pandemic, some countries may be tempted to revert to policies that lead to financial repression in order to reduce their debt burden. Our model shows how, in the presence of financial repression, domestic and external debt sustainability are interlinked. This link holds as long as there is a positive probability of joint domestic and external defaults. However, our model has abstracted from other potential costs that arise in an economy under financial repression, such as negative effects on growth. These costs have to be assessed together with the potential benefits of the reduced debt burden.

1. Other policies discussed to reduce the costs of debt service are debt relief programmes (Gourinchas and Hsieh, 2020), a debt moratorium (Reinhart and Rogoff, 2020) or ex-post state intervention in debt contracts (Bolton et al., 2020).

References:

Bolton, Patrick, Mitu Gulati, Ugo Panizza, "Legal air cover", Vox article, 13 October 2020.

Chari, V.V., Alessandro Dovis, and Patrick J. Kehoe, \On the Optimality of Financial Repression," Journal of Political Economy, 2020, 128 (2), 710{739.

D’Erasmo, Pablo, Enrique G. Mendoza, and Jing Zhang. "What is a sustainable public debt?." In Handbook of Macroeconomics, vol. 2, pp. 2493-2597. Elsevier, 2016.

Di Casola, Paola and Spyridon Sichlimiris, \Domestic and External Sovereign Debt", Sveriges Riksbank Working Paper, n. 345, 2017.

Escolano, Julio, Anna Shabunina, and Jaejoon Woo, \The Puzzle of Persistently Negative Interest Rate-Growth Differentials: Financial Repression or Income Catch-Up?," Fiscal Studies, 2016.

Gourinchas, P.-O. and C.-T. Hsieh, \The COVID 19 Default Time Bomb", Project Syndicate, April 9, 2020.

Krueger, Anna, \Financial repression revisited?", Project Syndicate, August 20, 2020.

Panizza, Ugo, \Domestic and external public debt in developing countries," Discussion Paper 188, United Nations Conference on Trade and Development 2008.

Reinhart, Carmen M., and K. Rogoff, "Suspend Emerging and Developing Economies’ Debt Payments", Project Syndicate, April 13, 2020.

Reinhart, Carmen M., and M. Belen Sbrancia, "The Liquidation of Government Debt", Economic Policy, Vol. 30(82), March 2015, 291-333.

Tirole, Jean, \How will we get out of the crisis?", TSE Post, April 2, 2020.