Finance Dr Katarzyna Sum Chair of International Finance Warsaw School of Economics THE PUBLIC DEBT AS A GLOBAL PROBLEM

Finance Lecture outline  Increasing debt levels in the world  Debt crisis- definition and mechanism  The case of the euro area sovereign debt crisis

Finance Government debt to GDP in the world Source: Wikipedia.

The Polish public debt clock Source: Finance

Government bonds  National government bonds- issued in domestic currency  Sovereign bonds- issued in foreign currency

Finance Government bonds  Low risk premium of government bonds:  Governments are able to undertake policy measures to pay off their debt (taxes, expenses)  The risk premium depends on the credibility of the government  Sovereign bonds – additional risk related to exchange rate movements and availability of foreign currency

Finance Problems related to public debt accummulation  Decreasing credibility  Increasing risk premia  Investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue

Finance Accummulation of public debt globally  Individual country factors  Global factors-  the financial crisis from ,  Global unequilibrium

Accummulation of public debt globally  The need to recapitalize banks after the crisis  Governments had to take over a large part of the debts of failing financial institutions  The introduction of large stimulus programmes to revive demand  Prospects of further debt increase due to demographic tendencies Finance

Accummulation of public debt globally  Total industrialised country public sector debt is exceeded 100% of GDP in 2011!!! (OECD)  Strong deterioration in countries which had a balanced situation before the crisis

Finance Further development will depend on:  The ultimate costs of the financial crisis  The rate of real growth  The level of interest rates,  Political decisions about spending and taxes

Finance Short term and long term spending  Short term- to mitigate the effects of the financial crisis  Long term- to deal with the ageing of societies

Finance Unfunded liabilities arising from ageing  The pension system is based on the pay-as you go method  This means that current pensions has to be financed by current contributions  Ageing of the population creates the need of additional borrowing

Finance Age related government expenditure Source: Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, The future of public debt: prospects and implications, BIS Working Paper 2010.

Finance Prospects Source: Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, The future of public debt: prospects and implications, BIS Working Paper 2010

Finance Debt crisis  A situation of excessive government debt accummulation which renders an economy incapable of paying off its debt without the help of third parties  A type of financial crisis

Finance Debt crisis  Initially high level of public debt creates the risk of unstable debt dynamics  Increasing risk premia  Lower long term growth due the higher cost of servicing the debt

What happens to bond yields during the debt crisis? Finance Source: Nicholas Vause, Goetz von Peter, Euro area sovereign crisis drives global financial markets, BIS Quarterly Review, December 2011

What triggered the sovereign debt crisis in the Eurozone?  The performance of respective Eurozone countries  Excessive lending, asset price bubbles and a loss of competitiveness   Overheating combined with structural problems  PIIGS Finance

Did the euro zone try to prevnet the debt crisis?  The Stability and Growth Pact Aimed at preventing excessive deficits and public debt  The no-bail out principle- the respective euro area member states are not liable for the debt of other member states

Finance Source: Nicholas Vause, Goetz von Peter, Euro area sovereign crisis drives global financial markets, BIS Quarterly Review, December 2011

Finance The preventive measures undertaken were not sufficient!  Even before the financial crisis countries did not comply with the Pact reqirements  The situation worsened when the governments had to fight the consequences of the crisis

Finance The reaction of the financial markets  High volatility of equity and bond markets  Downgrades of country ratings exerted additional upward pressure on government bond yields

Finance The reaction of the financial markets  The financial markets demanded higher risk premia- financing contsraint  Additionaly- bank funding problems  This created the need of policy measures to restore confidence

Finance Political measures  Debt remission for Greece  Leveraging of the European Financial Stability Facility  Recapitalisation of banks

Finance Political measures  The political measures undertaken contradict the no-bailout clause  The need of redefining the fiscal rules of the eurozone

Finance Securities Markets Programme  Interventions by the Eurosystem in public and private debt securities markets in the euro area to ensure depth and liquidity

Finance Securities Markets Programme Source: Nicholas Vause, Goetz von Peter, Euro area sovereign crisis drives global financial markets, BIS Quarterly Review, December 2011

Finance Global spillovers  After the decrease of the euro area soveriegn debt and bank debt the financial institutions which held the securities were exposed to increased costs  This affected institutions globally

Finance Debt crisis resolution  In the past debt crises were resolved by:  Economic growth  Substantive fiscal adjustment/austerity plans;  Explicit default or restructuring of private and/or public debt;  A sudden surprise burst in inflation  Financial repression

Financial repression „Directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements„ Source:Carmen M. Reinhart, M. Belen Sbrancia, The Liquidation of Government Debt, BIS Working Papers 2011 Finance

Debt crisis resolution  The resolution of the euro area sovereign debt crisis should consider:  Changing economic conditions  Demographical tendencies Finance

Summing up  Governments can borrow financial resources by means of issuing bonds  Bonds can be issued in national currency (national bonds) or foreign currency (sovereign bonds)  Usually governments bonds are regarded as risk free securities

Finance Summing up  The excessive accummulation of debt leads to an increase of risk premia and increases to costs of debt servicing  A debt crisis occurs if a country can jot repay its debt without the help of a third party

Finance Literature Source: Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, The future of public debt: prospects and implications, BIS Working Paper 2010 Nicholas Vause, Goetz von Peter, Euro area sovereign crisis drives global financial markets, BIS Quarterly Review, December 2011 Carmen M. Reinhart, M. Belen Sbrancia, The Liquidation of Government Debt, BIS Working Papers 2011