Define and explain sovereign debt

by Manshu on January 17, 2012

in Economy

Sovereign debt is the debt owed by the government of a country, and it is usually denominated in the national currency (domestic debt), and international currencies (external debt) like the USD, Euro, Yen, Pound Sterling or even the local currency.

The government needs to borrow money when its spending is more than its revenues (known as fiscal deficit) and for people who have read this blog long enough – you would probably remember India’s fiscal deficit target in the budget posts that I did last year, and how it clearly showed why the government needs to borrow money.

When the government borrows – it can borrow in its own currency or in a foreign currency. Since a country usually becomes vulnerable due to external sovereign debt and not domestic debt let’s focus on external debt in this post.

A government that needs to pay for foreign goods and one that doesn’t have enough foreign currency will have to borrow in a foreign currency.

This is a good time to easily understand this concept because of the context of Iranian sanctions and the oil we import from them. Very briefly, the background on this is that India imports a lot of oil from Iran, and Iran demands that India pays for it in US Dollars.

India uses a Turkish bank to facilitate this transaction and due to the recent sanctions by the US and EU – the Turkish bank is likely to refuse being the intermediary, and force India to look for another channel.

If Iran accepted Rupee payments for its oil then there will be no problem because India could settle with them directly, but since they don’t (at least yet, and not likely to accept in full in future either) – India will have to find a way to settle this transaction in dollars.

This is a good example to see why you need foreign exchange in the first place, which is a concept I’ve seen some people struggle with occasionally.

Now, the debt that a country owes others is usually referred to as external debt, and the external debt number is often published in the newspapers etc.

One important thing that is not highlighted when you read about India’s external debt is that it is not Indian government’s external debt – but rather the total of Indian government’s external debt and India’s private sector’s external debt.

In fact, the sovereign debt or Indian government’s share of external debt is as low as 25% of the total external debt, and is long term and concessional in nature. So, the total sovereign external debt is just about 25% of the total external debt that is reported.

This is markedly different from a country like Greece which has a lot of its debt going to mature soon and owes it to private borrowers.

India’s sovereign external debt is concessional, long term and borrowed from developmental agencies instead of private borrowers so you will never hear phrases like ‘bond vigilantes’ that you hear these days with reference to Greece’s debt.

Turning to domestic debt – that’s a lot easier to manage than external debt because a government can print its own currency, and pay back the debt or inflate away the debt. This doesn’t mean that it’s good to have domestic debt or that there are no harmful effects of domestic debt. They are certainly there – if the government borrows too much money then their future revenues are earmarked to pay interest on that debt, and money that could be used for building roads get diverted towards repaying interest. Since taxes form a major way of earning revenues for a government – they will have to raise taxes or broaden the tax base to meet the growing expense, and if the economy stops growing or the growth slows down then the government will see that a large part of its tax collection are simply used to pay the interest on its loans.

Finally, Dr. Paul Krugman had a good column on US government’s debt a few days ago and it gives you a good perspective on the difference between an individual’s debt and the government’s debt.

This post was from the Suggest a Topic page.

{ 8 comments… read them below or add one }

Vijay January 17, 2012 at 10:15 am

Timely post….the Middle East crisis is looming large esp.with threatening statements by Iran and US reg.blocking straits of Hormuz and recently,the assasinations of its top nuclear scientists and threat of Israeli airstrikes on Iranian military installations in Qom. I feel , given the tightening of sanctions,Iran,sooner or later will have to accept goods likefoodstuffs,clothes etc to tide over the problem of payments…btw,one question….why cant GOI buy Gold and pay Iran ???

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Manshu January 17, 2012 at 8:59 pm

I’ve not been able to figure out why that is – why can’t the RBI which has access to USD settle directly with the Iranian Central Bank? I’m not sure why that is.

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Carlos January 17, 2012 at 5:23 pm

Dear Manshu,

I would like to commend you on the well written article. It is very informative and in lay man’s terms. Imparting knowledge is a blessed job even though at times thankless and I hope that you are both blessed and rewarded in life.

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Manshu January 17, 2012 at 9:00 pm

You’re very kind Carlos – thanks a lot!

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Gaston Oliver February 14, 2012 at 2:27 pm

Sovereign debt is generally a riskier investment when it comes from a developing country, and a safer investment when it comes from a developed country.

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Praveen April 22, 2012 at 9:53 pm

Mr. Manshu,

Can u pls clear me about why in 2012-13 budget, customs duty on gold has been doubled? If the nation imports much of gold, it will be there in the economy or else in bank (which is as good as hard currency) so it would be good for the nation right. Actually from only from past few weeks am learning economics so kindly clear me abt this even if u feel its very/silly question…

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Paul November 24, 2012 at 3:58 pm

Great posts, all of them.
On the domestic debt, who is getting the interest payments from the government for this debt? Who is benefitting from it? You note that Interest payments and Debt servicing is 33% of total government expenditure which is huge (that was in Budget Part 2: Where does the government spend your money?). Where is that money actually going? Especially the domestic part (above you deal with the External debt).
thanks

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Manshu November 24, 2012 at 9:54 pm

Whoever buys the bonds and g-secs get the interest, so could be banks, mutual funds, individual investors, FIIs anyone.

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