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Lesson 1 of 5 · 12 min
Why and how sovereigns borrow
A national government borrows against its power to tax, so it is usually its country's safest and largest bond issuer; fiscal policy decides how much it borrows, and whether it is a developed or emerging market issuer shapes in which currency and at which maturities it can borrow.
In short
- A sovereign issuer is set apart by its legal authority to provide public goods and its power to tax economic activity in its jurisdiction. Tariffs, user fees and profits of government-owned enterprises are extra sources of repayment.
- Public accounts are often cash-based and leave out items such as depreciation of infrastructure and unfunded pension liabilities. An economic balance sheet adds expected future tax claims and promised future spending.
- Developed market (DM) sovereigns have stable, diversified economies and borrow in a widely held reserve currency at any maturity. Emerging market (EM) sovereigns grow faster but are less stable, and often borrow in a restricted currency or abroad.
- EM debt splits into domestic debt (local currency, mostly local holders) and external debt (owed to foreign creditors, including supranational loans and foreign-currency bonds).
- A DM investor in an EM sovereign's USD bond avoids direct currency risk but keeps indirect currency risk: the issuer must earn enough foreign currency to pay.
- Fiscal policy sets the level of sovereign debt; debt management policy sets its composition (short versus long term and other features).
What makes a sovereign different
A sovereign (national) government has the legal authority to set up and maintain a country's public goods and services, and it can tax economic activity within its borders. No company has a claim like that on a whole economy.
Taxes are the main source of repayment, but not the only one. Governments also collect tariffs and usage fees, and some receive cash from government-owned enterprises.
Because of the right to tax, the national government is normally the lowest-default-risk issuer among those borrowing in the domestic currency, and it is usually the largest bond issuer in its home market.
The government's economic balance sheet
Companies file periodic statements under accounting standards built on accrual principles. Public-sector accounting varies widely between countries and is often prepared on a cash basis. That typically leaves out items such as the depreciation of public assets (roads, bridges) and the build-up of unfunded liabilities such as civil-service pensions.
An economic balance sheet gives a fuller picture. Besides financial items such as fixed assets, FX reserves and outstanding debt, it includes expected future tax revenues as a claim and promised future expenditures as an obligation. That forward-looking view matters far more for a government than for a company.
How large the government sector is, and how its work is split between the national government, quasi-government agencies and local governments, differs a lot from country to country. That split is why non-sovereign public issuers exist alongside the sovereign (lesson 5).
| Claims and assets | Obligations |
|---|---|
| Fixed assets: infrastructure, land, government-owned firms | Short-term debt |
| Foreign exchange (FX) reserves | Long-term debt in domestic and foreign currency |
| Commodity and other reserves | Pensions and other domestic obligations |
| Expected future tax revenues | Supranational and external obligations; promised future spending |
Developed versus emerging market sovereigns
Developed market (DM) sovereigns have strong, stable, well-diversified economies. Their budgets are mostly regular, recurring spending financed by broad-based personal and business taxes, so fiscal policy is stable and transparent. They borrow in a major currency that foreign governments hold as reserves. Together this lets them issue what is often treated as default-risk-free debt, with unconstrained market access across the whole maturity range.
Emerging market (EM) sovereigns usually grow faster, but their economies are less stable and less diversified and swing more with the economic cycle. They often depend on one dominant industry, such as commodities, and may have more state-owned enterprises. Spending to expand infrastructure can exceed current tax revenue, which leads to external or supranational funding.
EM local-currency debt is often in a restricted currency or one with limited convertibility because it is illiquid. Such restrictions can deter foreign investors and make it hard for the government to borrow at long maturities in its own currency.
| Feature | Developed market | Emerging market |
|---|---|---|
| Economy | Strong, stable, well diversified | Higher growth, less stable, often reliant on one industry |
| Budget | Recurring outlays funded by broad taxes | Development spending can exceed tax revenue |
| Currency of debt | Major reserve currency | Often restricted or thinly traded domestic currency; foreign currency abroad |
| Market access | Unconstrained across maturities | Long-term domestic-currency borrowing can be limited |
Domestic debt, external debt and indirect currency risk
For EM sovereigns, separate domestic debt in the local currency from external debt, meaning debt owed to foreign creditors. Local-currency government bonds are mostly held by local banks and other domestic investors.
External debt of emerging and frontier sovereigns has two parts: loans from supranational lenders, and bonds sold to foreign private investors, usually in a foreign currency such as USD or EUR. External debt is not always in foreign currency, though: some EM sovereigns with stable exchange rates also sell local-currency bonds to foreign investors.
A USD-based investor buying an EM sovereign's USD bond has no direct currency risk: coupons and principal arrive in dollars. The risk is indirect. The government must earn or hold enough dollars, through exports, capital inflows and other international flows, to pay. A collapse in foreign-currency income can end in default on external debt even though the bond's currency never changed.
Think of a USD bond from an EM government as a bet on the country's dollar income. The currency risk has not disappeared; it has moved from your account to the issuer's ability to pay.
Level versus composition of debt
Fiscal policy determines how much a sovereign borrows. Spending, including debt service, is set against tax receipts, fees and other revenue: deficits raise the borrowing need, surpluses reduce it. Forecasts must also allow for how spending and revenue react to changes in growth and inflation.
Debt management policy determines the composition of that debt: the mix of short- and long-term issues, the currency, and whether coupons are fixed, floating or inflation-linked. Lesson 2 looks at that mix.
Worked examples
Example 1 Cash accounts versus the economic balance sheet
The Republic of Ostrevia publishes cash-based public accounts. Which of these items would most likely appear in an economic balance sheet but be missing from the cash accounts: (1) interest paid on bonds this year; (2) the yearly loss in value of the national motorway network; (3) civil-service pension promises not yet funded; (4) tax revenue expected over coming decades?
Example 2 Where the currency risk went
Ingrid, a USD-based fund manager, buys a USD-denominated 10-year bond of the Republic of Tamboria, an emerging market that earns most of its dollars from cocoa exports and tourism. A cocoa price slump and a fall in visitors cut the country's dollar income by a third. Has Ingrid avoided currency risk?
On the exam
Expect questions on why the sovereign is the lowest-default-risk domestic-currency issuer, what cash-based public accounts leave out, DM versus EM features, and why holders of an EM sovereign's foreign-currency bonds still face currency risk.
- External debt is not always foreign-currency debt: some EM sovereigns sell local-currency bonds to foreign investors.
- A USD bond from an EM issuer removes only direct currency risk; the issuer still has to earn dollars.
- Fiscal policy sets the level of debt; debt management sets the composition. Do not swap them.
- Cash-based public accounts usually exclude depreciation and unfunded pension liabilities; FX reserves and long-term debt are included.
Check yourself
Q1A national government is usually the lowest-default-risk issuer in its domestic currency mainly because it:
Q2Which item is least likely to appear in a government's cash-based public financial statements?
Q3Decisions on the mix of short-term and long-term sovereign debt are the domain of:
Q4Compared with a developed market sovereign, an emerging market sovereign is most likely to:
Q5A EUR-based investor holds EUR bonds issued by an emerging market sovereign. The investor's currency exposure is best described as:
Answer the 5 questions: +10 XP for each one you get right first time.
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