Perplexing Sovereign Debt to GDP Ratio:
Between 237% (2017) Japan and 59% (2018) Argentina,
which is more Risky?
Published: 25 October, 2018
Edited: 26 October, 2018
by Michio Suginoo
‘Gross Sovereign Debt to GDP ratio (Gross SD/GDP Ratio)’ is a measure to compare the level of sovereign government debts among different peers. In this measure, Japan has the world top position of 237% in April 2017 (Chart 2); and Argentina has 56% in 2018 (Chart 1). Apparently, Japan is far more deeply indebted than Argentina. On the other hand, the credit ratings of their sovereign bonds cast a totally different story. While Japan’s government bonds (JGB) possesses an investment grade rating—rated A1 by Moody’s (December, 2014), A+ by S&P (April, 2018), and A by Fitch (April, 2017)—Argentina’s government bond (AGB) has a speculative/non-investment grade rating—rated B2 by Moody’s (November, 2018), B+ by S&P (August, 2018), and B by Fitch (May, 2018).
Are you perplexed?
If not, here are two very natural questions:
Simply put, this counter-intuitive relationship between ‘Gross SD/GDP Ratio (Sovereign Debt to GDP Ratio)’ and ‘credit rating’ is shaped primarily, if not only, by the difference in the denomination of sovereign debts between these two countries. On one hand, JGB (Japan’s Government Bonds) are denominated in its own local currency, JPY (Japanese Yen). On the other, a significant portion of AGB (Argentine government bonds) are denominated in foreign currencies, predominantly in USD (Chart 3). This difference leads to a contrasting and critical difference at the time of the maturity of existing debts (the repayment of existing debts to their creditors). This content focuses on this primary driver, the denomination of sovereign debts, that divides the implications of ‘Gross SD/GDP Ratio’ in sovereign’s solvency risk (credit rating).
Here, in order to put them into a perspective of insolvency risk, let’s contemplate a crisis situation under the following two assumptions:
Under this hopeless situation, what can they do?
As of today—whether it works forever is a different question to be discussed later—for Japan, it is a matter of issuing its own currency to service its outstanding sovereign debt, simply because its debts are denominated in its own currency. This is called ‘monetisation’ of sovereign debt. The monetised portion of its debt does not necessarily need to be repaid (to be explained). Thus, it is not a compulsory liability in a strict sense. In this sense, Japan appears to have no insolvency risk. Is that so simple? Can Japan increase its debt indefinitely through monetisation? This would be discussed later.
On the other, given the same conditions, Argentina, in order to pay back the foreign denominated portion of its sovereign debt, needs to get the foreign currency denominating its debt. Thus, for the case of Argentina, the sovereign debt management would involve currency risk: solvency risk and currency risk become the two sides of the same coin in Argentine sovereign debt management. For the case of Japan, currency risk has no direct involvement in the repayment process of sovereign debt. This difference in the denomination of sovereign debt can result in a critical difference in solvency dynamics.
Despite the fact that this difference is not the only factor that differentiates these two countries, it is a fundamental difference in the architecture of their sovereign debt management. Keeping this notion in mind, let’s compare the economic dynamics of these two countries’ sovereign debt management, one by one. Now, we start with Argentina.
Now, how about Argentina? Repeatedly, our question is: while Argentine government’s ‘Gross SD/GDP Ratio’ is around 59% (Chart 1), well below the case of Japan, why is Argentine credit rating lower than Japan’s rating?
As stated earlier, a significant portion, around 70 %, of AGB (Argentine’s government bonds) is denominated in foreign currencies (Chart 3), predominantly in USD. That exposes Argentine sovereign debt management directly to currency exchange risk. That imposes on Argentina extra constraints that Japan does not face. Although there might be multiple ways to slice the constraining dynamics, let me portray the dynamics in the Strained Triangle illustrated in Figure 1: the presence of foreign-currency denominated sovereign debts constrains three objectives: sovereign debt management; full sovereign discretion in fiscal policy; and full sovereign discretion in monetary policy. (Caution: This is different from the famous ‘Mundell-Fleming Impossible Trinity.’)