"There’s a rumor going around that states cannot go bankrupt," German Chancellor Angela Merkel said recently at a private bank event in Frankfurt. "This rumor is not true."

Previously the Pakistan President Asif Ali Zardari has been quoted as having said that Pakistan is not a private limited company which can go bankrupt. This simple statement, in fact, makes two assertions. One, that private companies can go bankrupt and secondly that the State not being a private company cannot go bankrupt. While the first is simply tautological, the second does not necessarily follow logically, i.e. that because a state is not a business concern, it cannot therefore go bankrupt.

We can then legitimately ask the question: Can a state go bankrupt? In order to answer that question we must first look at the concept of bankruptcy. In the ordinary sense, bankruptcy is a term applied to insolvent individuals or companies who surrender, voluntarily or otherwise, their assets in satisfaction of their debts. In the first instance therefore the basis of bankruptcy is insolvency. An insolvent entity is one that is unable to pay, or has ceased to pay, debts as they fall due. An insolvent business can be declared bankrupt, be dissolved and its assets sold for the benefit of its creditors.

The creditors may not get the full value of their outstandings, but once a settlement is made the debtor is discharged from any further obligations. Thus, bankruptcy implies a total discharge from responsibility for past indiscretions. Unfortunately, a state does not enjoy the luxury of being discharged from its past obligations. A state cannot therefore go bankrupt in the normal commercial sense of the word. A state must carry its past commitments into the future.

The costs of sovereign default

Even when a state ceases to exist or when a regime collapses under military defeat, its successor state must assume many of its obligations. Thus an insolvent or indigent state must remain in business. Many new or altered states, including Pakistan, have had to own up to their past obligations. The Federal Republic of Germany could not repudiate its Nazi past and both war reparations and compensation to Jews was imposed on it. The consequences of insolvency are never benign for the debtor nation. Creditors have gone to the extent of annexing territories of debtor nations. French and Belgian troops occupied the industrial heartland of Germany in 1922 to coerce it to continue reparation payments. After defaulting on loans, Newfoundland voluntarily surrendered its self-governing dominion status to the British until it joined Canada in 1949.

Many Asian and African states suffered much worse ignominy when they failed to meet their financial obligations to foreign lenders. Major trade and military concessions were extracted by lenders from such impoverished states as Imperial China and Egypt under the Khedives. Indeed, in the age of colonialism, empires were sometimes built on the debris of insolvent states. So foreign debt is a dangerous situation and no country can afford to default on foreign debt. The Central Bank assures us that all is well and that it can mobilize sufficient foreign exchange to strengthen our Foreign Reserves. The CB has started a campaign to sell Treasury securities to Sri Lankans resident abroad who have RFC or NRFC accounts.

Is German Chancellor Angela Merkel therefore right? Countries can go bankrupt if they allow their deficit spending to spin out of control and are no longer able to service their interest payments. Of course a State can nowadays always pay its debts to domestic clients by printing money since debts have to be settled in paper money which is legal tender. But printing money is not a desirable option for sooner or later investors in government securities will realize that they are being cheated. Their original capital invested would be worth much less when they are repaid since inflation would have eroded the purchasing power of the money.

Costly bailouts

The developed countries are spending enormous amounts of money to bail out their financial institutions. Economist Nouriel Roubini estimates that losses in the financial sector will total $3.6 trillion in the USA. The borrowing (not money creation) being done by countries to finance the bailouts, economic stimulus programs and shortfalls in tax revenues will create a lasting burden. Worse, with the decline in the banking sector continuing, it is unclear that such massive spending will be effective.

One can also look to the example of Italy, which is on track to join a rather exclusive — and undesirable — club. At 106 percent of gross domestic product, Italy will have the third-largest national deficit in the world. Ours is around 85%. Italy is a country that has long had a solid savings rate and deficit spending hasn’t proven to be a huge problem in the past. This year, Rome has to pay back 220 billion euros in short-term bonds. Finance officials have been quoted as saying that were a single bond issue to find no takers, it "would be a disaster for the state."

"It would create a liquidity problem for paying salaries and pensions and we would end up like Argentina," they say. There is also the case of Russia under President Yeltsin where the state was bankrupt and could not pay salaries to its staff which included the military.

Worst case scenario

The debt service payments of our government as at the end of 2007 was Rs 602 billion which includes both amortization payments as well as interest on both domestic and foreign debt. Interest payments were Rs 210 billion. The position today must be much higher. What is noteworthy is that the total debt service payments exceed total government tax revenue. So the Government must borrow more to roll over the debt. Alternatively the government can print money to cope with domestic debt servicing. But it has no solution to service foreign debt except by borrowing from foreign sources what is required to service foreign debt since the money printing option is not there.  But foreign commercial debt has dried up partly due to the global financial crisis and partly to the lower credit ratings we now have.

The Central Bank can bring down the rates of interest in the short term market by creating money but it is not able to determine the course of long term interest rates. But bringing down interest rates acts as a disincentive to savers who want to lend to the government. Presently owing to the run on Golden Key and some finance companies, people have lost confidence in all finance companies. So the people will invest in government securities even if the yield is low because they prefer security of their capital. But the country needs the finance companies and it is time that the authorities took some action. Other countries have tackled such a problem by introducing deposit insurance or deposit guarantees. It is true that this will worsen the public finances since the state will be undertaking contingent liabilities which could become extra expenditure from the budget. But it would be a worse disaster to let the finance companies fail or suffer slow death. 

Our past efforts at fiscal consolidation by which is meant the bringing down of the budget deficits and the public debt to levels specified in the Fiscal Management (Responsibility) Act of 2003 have failed. Each government leaves the task to a future government. For some governments budget consolidation is the last thing on their minds.

Whether a country can borrow cheaply or not depends on its credit rating. We have so far not ever defaulted on our foreign debts. The necessity does not arise for domestic debt since enough rupees can be printed to pay off debtors. But it is becoming impossible for us to borrow cheaply or for that matter to borrow at all from foreign sources. The CB has had to cancel Treasury bond auctions because the investors are demanding higher yields. Of course, given the nature of the current crisis, the debt burden will rise as tax revenues fall or remain stagnant. In inflation adjusted terms of course tax revenues will decline steeply.  Nobody knows how high the debt will run nor how the country can eliminate it before it starts to get strangled by interest payments.

The interest burden was around 37% of government revenues last year. It is therefore no wonder that our credit ratings have fallen. But if that figure goes up much more, the country might lose the even the present poor ratings, causing its foreign financing costs to soar.

Strangled by interest payments