foreign debt versus domestic debt in the euro area

doi:10.1093/oxrep/grt038© The Author 2013. Published by Oxford University Press. For permissions please e-mail: [email protected]

Foreign debt versus domestic debt in the euro area

Daniel Gros*

Abstract The aftermath of the 2008 financial crisis has led to a sharp rise in public debt throughout the developed world. The problem is particularly acute within the euro area, where several govern-ments needed financial assistance from the International Monetary Fund and the European Stability Mechanism. This paper argues that public debt poses much greater problems when it is owed to for-eigners, i.e. when it constitutes foreign debt. This view implies that the key to overcoming the euro crisis is in the external adjustment, not the fiscal adjustment. Another implication is that in a crisis a strong fiscal adjustment is desirable, not because it can immediately reduce the public debt/GDP ratio, but because it reduces domestic absorption and thus reinforces the external adjustment.

Key words: debt, debt management

JEL classification: H63

I. Introduction

The ‘euro’ crisis has rekindled interest in sovereign debt in Europe. It is clear that the root of the problem has not always been an excessive accumulation of sovereign or public debt. For example, in the case of Ireland and Spain the debt-to-GDP ratios before the crisis were actually falling and considerably below the European average. The underlying problems of these countries had been an excessive accumulation of private debt in the context of domestic real estate booms. However, when the booms ended, a significant part of this private debt became public debt (especially in Ireland) and the depression of economic activity which followed the end of the real estate booms led to large deficits which led to a further increase in public debt. In the end, public debt thus came to the forefront in all countries affected by the ‘euro crisis’. This is the reason why the current crisis in the euro area is also often called a ‘sovereign debt crisis’.

But some reflection shows that the euro crisis is not really about sovereign debt in general, but about foreign debt, i.e. sovereign debt held by foreign investors. Indeed, it is widely agreed that the euro crisis is at its heart a balance-of-payments crisis.

* Centre for European Policy Studies, e-mail: [email protected] support from the Belgian Federal Science Foundation is gratefully acknowledged. Many

thanks to Matthias Busse for research assistance and to the editors and the referee for very helpful comments and suggestions. Any remaining errors are mine.

Oxford Review of Economic Policy, Volume 29, Number 3, 2013, pp. 502–517

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It started with a ‘sudden stop’ to capital which used to flow within the euro area from the surplus countries in the North (principally Germany and the Netherlands) to countries such as Spain, Ireland, Greece, and Portugal. These countries are today considered the periphery of the euro zone, but until 2007 they were growing rapidly and seemed to be catching up with the North. The counterpart to the capital inflows were large current account deficits. When the flows of capital dried up then both the governments and the private sector in these coun-tries had difficulties financing ongoing deficits and rolling over the existing stocks of debt.1

The most visible symptom of the crisis was that several governments were no longer able to finance themselves by selling their debt in the market and thus had to ask for support from the International Monetary Fund (IMF) and the European rescue fund (the European Stability Mechanism, ESM). This created the impression that excessive fiscal deficits and high public debts had brought these countries to the brink of default.

Default is the extreme outcome of a public debt crisis. Most of the existing literature on debt and default on public debt was written after the prolonged crisis of develop-ing economies during the 1980s and assumes—often implicitly—that the debt is owed to foreigners (see, for example, Krugman, 1988). More recently Reinhart and Rogoff (2009) distinguish foreign and domestic debt, but their implicit assumption is that for-eign debt is in foreign currency and domestic debt is in domestic currency. But this is not the case within the euro area, at least in the sense that no individual member coun-try of the euro zone can control the European Central Bank (ECB).

If one defines ‘domestic’ currency as a situation where the home country can deter-mine the monetary policy of the currency in which the debt is expressed, one can clas-sify the different combinations of domestic/foreign for public debt and the currency in the following matrix:

In the ‘normal’ case (the country has its own currency) there are two ways a govern-ment can deal with a large debt burden: it can either tax its citizens or inflate the debt away. The US seems to be the only country which has the ‘exorbitant’ privilege of being able to sell a significant part of its public debt denominated in its own currency to for-eigners. It is estimated that at present close to one-half of the marketable US federal debt is held abroad, mostly by official institutions, such as central banks as part of their

1 See Gros and Alcidi (2011) for a detailed analysis of this ‘sudden stop’. The genesis of the euro crisis is not too different from the busts that have followed other credit booms. The key characteristic of a boom is a significant increase in private debt and leverage based on the belief that the good times will continue. The key characteristic of the subsequent bust is the explosion of public debt as private debt cannot be serviced and tends to become public.

Debt owed to whom

Domestic residents (=> can tax away) Foreigners

Control over currency Domestic (=> can inflate away)

‘Normal case’ Reserve currency country (US)

Foreign Euro area (Belgium, Italy)

Emerging market and some euro area (GR, PT)

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foreign exchange reserves. These central banks also hold some assets in pounds sterling and Japanese yen, but the amounts are an order of magnitude smaller.

The fact that most of its foreign debt is denominated in US dollars implies that the US could deal with its foreign debt through (surprise) inflation should the foreign debt burden become too large. However, euro-area countries are not in this position as none of them has, individually, any influence over the policy of the ECB.2 In the 1980s it was widely argued that the market for public debt should be more stable if the government cannot have access to central bank support. Giavazzi and Pagano (1986) thus empha-sized the ‘advantages of tying one’s hands’. With the onset of the euro crisis the oppo-site view has been proposed, namely that the absence of central bank support exposes the government to the danger of a self-fulfilling liquidity crisis (Kopf, 2011; de Grauwe, 2011) and thus destabilizes the market for public debt.3

For a euro-area country public debt (denominated in euro) is thus essentially denom-inated in a ‘foreign’ currency.4 But this contribution argues that the currency of denom-ination might be less important than who holds this debt—foreigners or domestic residents.

This paper is organized as follows. The next section argues that the economics and political economy of public debt are quite different depending on whether it consti-tutes predominantly foreign or domestic debt. Section III then provides some empirical evidence, both anecdotal and more systematic, that within the euro-area risk premia depend on the foreign debt of a country. Section IV then looks at various complica-tions that arise if one wants to determine the foreign debt of a country. Section V then discusses briefly the importance of a particular class of domestic bondholders, namely domestic banks. Section VI concludes.

II. Public debt, foreign versus domestic

Public debt owed to foreigners is different from debt owed to residents, both from a political economy and a pure economic point of view.

From a political point of view the difference is clear: foreigners cannot vote for the higher taxes or lower expenditure needed to service the debt. It is therefore much less likely that a highly indebted government would obtain a majority for these politically

2 Collectively this is not the case. If all member countries acted together they could change the EU Treaty and enforce a different monetary policy.

3 For more on this shift in views see Gros (2011). Calvo (1988) considers both the case of a country with monetary autonomy and the case of a country without monetary autonomy. He finds that multiple equilibria can arise in both cases.

4 Officially this view is, of course, anathema. The official view is that the euro is the currency of all of its member states and hence the euro must be regarded from a legal point of view as the domestic currency. This dichotomy between the economic and legal point of view had consequences which were brought into focus by the euro crisis and the Greek de facto default: within the euro area, the usual modern assumption in finance theory and banking regulation, namely that public debt is riskless (in nominal terms), does not hold because no individual euro-area country has access to the printing press (which is what makes government debt risk-free in nominal terms in countries with their own currency). In this sense the euro area is similar to the gold standard.

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difficult measures if the debt service was destined for foreigners. By contrast, domestic debt holders can and will vote for the measures needed to pay them.

From a purely economic point of view there is also a fundamental difference: a higher interest rate or risk premium just leads to more internal redistribution (from taxpayers to bondholders) in the case of domestic debt. A default on domestic debt might disrupt the domestic financial system, but it is just another form of redistribution and thus does not increase the aggregate consumption possibility of the country. By contrast, in the case of debt owed to foreigners, higher interest rates lead to a welfare loss for the country as a whole because the government has to transfer resources abroad. A larger transfer to foreigners in turn usually requires a combination of a depreciation of the exchange rate and a reduction in domestic expenditure. And a default on foreign inves-tors increases the consumption possibilities of the country because the reduction in debt service can be used to finance additional imports.5

The key point is that euro-area member states retain their full taxing powers. This has a simple corollary if one takes a country with a high public debt but no external debt at all. In this case its public debt must be held by residents and the government can always service its debt by some form of lump-sum taxation (e.g. a wealth tax). For example, the government could just pass a law which forces every holder of a government bond to pay a tax equivalent to 50 per cent of the face value of the bond. The value of pub-lic debt would thus be halved, much in the same way as it would be if the government ordered the central bank to double the money supply, which would presumably lead to a doubling of prices. The nature of the tax needed to pay off public debt might be different if public debt were held by banks, because in this case the government would have to tax the holders of bank deposits. But the key point remains: as long as a govern-ment retains its full taxing powers it can always service its domestic debt, even without access to the printing press. However, this is not the case if the debt is due from foreign-ers, because the government cannot tax them.

The negotiations that preceded the agreement on a rescue programme for Cyprus by the European Stability Mechanism (EMS) in March 2013 illustrate the validity of this point. The first adjustment programme agreed between the European authorities and the government of Cyprus was based on a one-off tax on all bank deposits (of between 6 and 10 per cent).6 The parliament of Cyprus refused to ratify this agreement, but in principle it could have been adopted and would have provided an illustration of the tax-ing power of the sovereign over its residents, given that a majority of all deposits were held by residents. The agreement which was finally reached was quite different in that it involved only a loss for large deposits at the two banks which had to be restructured. Most of these deposits were held by foreigners. The solution found in the end was thus tailored to affect mostly foreign depositors. Of course, some domestic residents with large deposits also lost, but among those with large deposits foreigners constituted a clear majority (and they could not demonstrate in front of the Cypriot Parliament).

5 This might be the key reason why Reinhart and Rogoff (2009) find approximately five times as many defaults on foreign debt, as on domestic debt.

6 Given that, in a systemic crisis situation, bank deposits are de facto government obligations as well, this (attempted) tax on bank deposits was equivalent to a tax on government debt. A wealth tax has been widely discussed in Italy as a way to reduce public debt (a small tax on bank deposits was imposed in the 1990s to con-tribute to the fiscal adjustment necessary to allow Italy to satisfy the Maastricht criteria and thus join the euro).





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It is thus the foreign debt which constitutes the underlying problem for the solvency of a sovereign. (As argued above, the US is an exception given that it enjoys the ‘exorbi-tant privilege’ of having its foreign debt denominated in its own currency, giving the US the potential to cut the real value of its foreign debt simply by printing more dollars.)

III. Foreign versus domestic debt in the euro area

This difference between the economic effects of foreign and domestic debt has been particularly important in the context of the euro crisis. In some countries (Italy) the debt is mainly domestically held, whereas in others (Greece) it is mainly foreign.

The case of Belgium is particularly interesting because the risk premium on Belgian government debt has remained modest throughout most of the euro crisis period, although the debt ratio of the country is above the euro-area average (around 100 per cent of GDP)—and it went without government for over a year. But Belgium, in con-trast to Portugal or Spain, has run current account surpluses for a long time and thus accumulated a large stock of foreign assets.7

An even starker example of the crucial difference between foreign and domestic debt is provided by Japan, which has by far the highest debt to GDP ratio among OECD countries, but (at least so far) the country has not experienced a debt crisis and interest rates remain at around 1 per cent—exceptionally low.

The difference between foreign and domestic debt should be apparent in the pricing of sovereign risk. More systematic evidence on this is provided by the contribution of John Muellbauer in this issue (Muellbauer, 2013). In general it has been difficult to document any stable link between the interest rates on public debt and any macroeco-nomic variable (see De Grauwe and Ji, 2012). The reason is that interest rates (or the risk premia, i.e. the difference between these rates and the benchmark, usually taken to be the rate on German government bonds) have been extremely volatile since the out-break of the crisis, changing significantly in the space of weeks and months, whereas macroeconomic variables move more slowly. But one can still find significant and stable cross-country correlations which have held up over the whole crisis period. One such correlation is between foreign debt, relative to GDP, and interest rates on public debt.

This is apparent in Figure 1 which shows on its horizontal axis the net foreign assets position of euro-area countries, defined here as the sum of the current account balance over the crisis period and the sovereign spread, i.e. the interest rate on national public debt relative to that of Germany. It is apparent that there is a strong, but non-linear relationship between the two. The non-linear character of the relationship is easy to understand from the point of view of the literature on credit rationing. Table A1 in Appendix I shows that this (non-linear) correlation holds up well, even if one looks at

7 The contrast with the case of Portugal is instructive. During 2010 the risk premium on its public debt continuously increased until the country was forced to go to the European rescue fund (the European Financial Stability Facility—EFSF) although the public debt and deficit ratios of Portugal were broadly simi-lar to those of France. The key problem for Portugal was thus not fiscal policy, but the high (foreign) debt of the country as a whole, which was partially accumulated by the Portuguese government, but even more by its private sector, i.e. its banks and enterprises.

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average interest rates over a longer period, whether one considers the highest interest rate observed over the entire period and for slightly differing definitions of public debt.

IV. What is foreign debt in real life?

Economic models are usually based on a simple approach. The ‘foreign debt’ of a coun-try is defined as the amount of public debt held by foreigners. This might have been a useful approach for developing countries in the past, when the private sector had little access to international financial markets and the government was therefore the only agent, which could finance external deficits. However, this is clearly not the case for the euro area, with its open financial markets.

If financial markets were perfectly integrated in the euro area, one would expect that all investors in a given risk class would hold the same portfolio of bonds and other assets. This implies that all those investing in bonds should hold the same basket of the bonds of different countries. An Italian investor would not have any reason to hold more Italian debt than a German investor with the same risk preferences (and vice versa). In equilibrium this implies that all investors would hold a portfolio of bonds with the relative weights equal to the shares of the national debt in overall public debt of the euro area.

It follows that, even for the largest member countries, most public debt would be held by investors abroad, since the weight of German public debt in overall euro-area debt

Figure 1: Sovereign spread vs current account

Sources: ECB, Ameco.





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is below 30 per cent. This implies that, even for Germany, the share of German debt in the overall portfolios of euro-area investors would be below 30 per cent. In a financially integrated area most public debt should thus, in principle, be held abroad8 (but princi-pally within the same currency area, given that most investors have a ‘home currency bias’, i.e. a strong preference for investing in their home currency).

Over the first 10 years of Economic and Monetary Union (EMU), the trend was towards diversification, with the proportion of government debt held abroad rising significantly for all countries, as shown for the larger euro-area member countries in Figure 2. Before EMU most public debt was held domestically, with the share of domestic investors amounting in most cases to about 75 per cent. Before EMU most public debt was thus mostly domestically owned, and current account imbalances had anyway been much smaller, implying that the net foreign debt positions of most coun-tries were much smaller.

During the first decade of EMU the proportion held by foreign residents increased steadily as the introduction of the euro fostered financial market integration (and the temporary illusion, until the de facto default of Greece in March of 2012, that all euro-area government debt was in the same risk class). By 2008/9 the proportion held abroad had reached about 50 per cent for both Italy and Spain.

Figure 2: Percentage of public debt held by non-residents

Sources: National Central Banks and Ministries of Finance.

8 In a world in which all investors hold the same expectations and there are no other financial market frictions it might not matter who holds government debt. In reality, however, financial market frictions play a key role. In most countries the savings of domestic households are intermediated by domestic financial institutions, whose investment choices can be influenced by the domestic authorities, in particular financial market supervisors.

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With the onset of the crisis the home bias returned, with foreign holdings falling to about 40 per cent of the total for Italy, and even more in the case of Spain, where by the end of 2012 non-residents held only 29 per cent of the total, not much more than when Spain still had the peseta. There are a number of reasons for this return of the ‘home bias’. First of all, during a crisis the incentives for financial institutions are no longer the same across countries: in the countries with high risk premia banks have an incentive to invest in high-yielding domestic government debt because this offsets, at least partially, their higher refinancing costs; and nobody could be held responsible for not foreseeing the default of its own government. Moreover, governments naturally encouraged this tendency of their own banks to support the market for their own debt when the risk premium is high and market access uncertain.

By contrast, the share of German public debt held abroad has continued to increase, even after the onset of the crisis, probably mainly due to investors from third coun-tries, often central banks which did not want to take any risk with their euro foreign exchange reserves and thus probably sold or did not roll over their holdings of Italian and Spanish bonds.

The case of Germany shows that even large foreign holdings of government debt do not always have to signal a high foreign debt for the country as a whole.

Germany constitutes an extreme case of a country with a large stock of net for-eign assets and where most public debt is held by foreign residents. More generally it becomes difficult to determine whether foreign or domestic debt is more relevant when a large part of public debt is held by foreign residents but residents own also large for-eign assets.9

Another complication in determining the foreign debtor position of a country is that one has to distinguish between debt, i.e. claims fixed in nominal terms, and other ‘non-debt’ liabilities, for example, foreign direct investment (FDI) and other equity. The key difference between FDI and portfolio equity (i.e. so-called ‘non-debt creating capital flows’) and debt (bonds or bank loans) is that in a crisis no payments need to be made on these liabilities, whereas any missed payment on a principal or interest on debt instruments leads immediately to a default situation.

Within the euro area most of the cross-border capital flows have been in the form of debt (bonds or bank loans) so that, in practice, this distinction between debt and non-creating capital flows is not that important.10

When there are large gross positions of different signs the incentives might be skewed: the government faces the temptation to default on its foreign debt while its citizens can

9 Within the euro area the distinction between short-term and long-term debt is less relevant, given the availability of liquidity support from the ECB. Governments usually finance themselves with maturi-ties that average between 5 and 7 years. Most cross-border short-term debt is thus contracted by banks and non-financial institutions. While large short-term debt has been the key issue in balance-of-payments crises all around the world, this is not an important issue within the euro area, given that the ECB has so far been accommodating in providing short-term liquidity support.

10 Gros (2012) calculates a hypothetical ‘recovery value’ by simply comparing foreign debt (in the narrow sense, i.e. excluding equity, which is loss absorbing) to total foreign assets (including equity abroad, whose value is not affected by domestic difficulties). The difference between these two figures gives the amount the country would not be able to repay if it were able to liquidate all its assets to pay off its foreign creditors (but not foreign equity holders). These calculations show that cross-border equity investment can play at the margin an important role in reducing the risk of insolvency (which would result from a low recovery value).





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still enjoy the returns from their foreign assets. This temptation to default will be the greater the more difficult it is for the government to tax the foreign assets of its residents.

The importance of these points was illustrated by the case of Argentina in 2001, where the country as such did not have a large net foreign debt. That this was the case can be deduced from the fact that Argentina had never run large current account defi-cits, most of the time less than 3–4 per cent of GDP. Moreover, equity inflows in the forms of FDI and portfolio investment had been more than enough to cover these defi-cits.11 What mattered in the case of Argentina were the gross debt positions of differ-ent sectors: the private sector had substantial foreign assets, while the government had about the same amount of foreign liabilities. However, Argentina went bankrupt even though the country as a whole had little net foreign debt, because wealthy Argentines had spirited their assets out of the country, and thus out of the reach of the govern-ment, while poor Argentines refused to pay the taxes needed to satisfy the claims of the foreign creditors.

However, when the foreign assets of the country are held not by households, but by institutions, such as pension funds, they can be identified and taxed by the government. This is mostly the case in Europe. Very strict EU regulations against money laundering force these institutions to hold detailed records of the assets of their clients. Moreover, institutions managing client moneys also have to deduct taxes on interest and other revenues at the source, making it thus even easier for governments to tax foreign returns if they wished to do so.

V. Foreign debt and public debt and the financial sector in a default situation

The importance of the distinction between public and foreign debt was illustrated in practice in the case of Greece, but with a particular twist which has a more general importance. Officially the so-called private sector involvement (PSI) concerned all pri-vate holders of Greek government bonds (GGBs). At the time of the PSI operation (March 2012) close to €200 billion of GGBs were still outstanding, of which about €80 billion were held by Greek financial institutions, mostly banks and pension funds. Formally, the holdings of Greek financial institutions were treated just like those of foreign banks or other foreign holders of GGBs. For each €100 nominal amount of a Greek government bond they received cash and other securities nominally worth about €45 (the market value was initially much lower). But this would have bankrupted the Greek banking system and Greek pension funds and deepened the already severe reces-sion the country was undergoing. This is why these institutions had to be recapitalized immediately—but this was possible only through new loans which the European rescue fund, the ESM, gave to the Greek government. This is why the PSI operation reduced the debt of the Greek government by a much smaller amount than one would have expected if one looked at the total amount of government bonds still outstanding at

11 Between 1980 and 2001 (the year the government defaulted on its foreign debt) the country had accu-mulated current account deficits totalling US$101 billion. Portfolio equity and FDI liabilities amounted to US$114 billion at the end of 2001.

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the time. In reality only the foreign (private) bondholders (and a few non-institutional private domestic ones, i.e. a few Greek households) were subject to the haircut.

The aim of the Greek PSI operation of early 2012 was to reduce public debt to a sustainable level which the IMF had estimated to be 120 per cent of GDP. Given that de facto only (private) foreign debt holders could sustain losses, it followed that the proportional loss that they had to accept was correspondingly higher.

This practical consideration, that it is not possible to impose a large haircut on hold-ings of government bonds by the financial system without risking a collapse of the economy (and thus the capacity of the government to service its debt), is of course valid beyond the specific case of Greece. Appendix II presents a small stylized model of this issue and shows that, in general, the risk premium demanded by foreign investors to hold the debt of a country should be higher the larger the proportion of this debt held by domestic financial institutions.

This channel, the vulnerability of the domestic financial system, constitutes another reason why the key variable in a default situation (and when there is even a remote pos-sibility of a default) is not so much the public debt of the country, but also how much of it is held by domestic residents which de facto cannot be bailed in.

In the euro area one key official financial institution is de facto also senior to private (foreign) bondholders, namely the ECB. This became apparent during the Greek de facto default, when the ECB did not participate in the PSI operation which resulted in a loss for foreign bondholders of over 50 per cent.12 The ECB had earlier (in 2010 and 2011) bought large amounts of Greek government debt in the context of its so-called ‘Securities Markets Programme’ and thus held a significant fraction of all Greek gov-ernment bonds when the PSI operation was implemented. This restricted further the amount of debt which was ‘hair cuttable’ (in the parlance of market participants). See Gros (2012) on the quantitative importance of this subordination of private bondhold-ers to the claims of the ECB.

VI. Concluding remarks

The key proposition of this contribution to the Oxford Review’s issue on sovereign debt is based on the observation that governments cannot tax foreigners. But even within the euro area, governments retain their coercive power over their own residents. This implies that, in principle, a government should always be able to service its domestic debt (whether it is willing to do so in practice is another matter). This leads to the proposition that foreign debt matters more than public debt.

An important corollary for the flow dynamics is that the key adjustment variable in a crisis situation is not so much the fiscal deficit, but the current account balance. If foreign creditors are not willing to provide additional resources, a period of current surpluses is needed to service foreign debt. This can also be looked at from a different

12 Just before the PSI operation, which was pro forma voluntary, the ECB had agreed with the Greek government to exchange its bond holdings for other bonds with a different listing number, but otherwise exactly the same conditions. Only the bonds with the listing numbers held by the ECB were then exempt from the PSI operation.





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point of view: a country with a balanced current account has, by definition, a sufficient flow supply of domestic savings to finance not only all domestic investment, but also the fiscal deficit.

The view that the euro crisis is at its core a balance-of-payments crisis implies also that the debate about austerity is misleading. It has often been pointed out that auster-ity can be self-defeating in the sense that a reduction in the fiscal deficit can actually lead in the short run to an increase in the debt-to-GDP ratio if both the initial debt ratio and the multiplier are large.

However, austerity can never be self-defeating for the balance-of-payments adjust-ment. To the extent that a fiscal adjustment (i.e. a reduction in the deficit) depresses domestic demand, it actually contributes to an improvement in the current account. A corollary of this observation is that a higher fiscal multiplier (i.e. a larger fall in domestic demand in response to an increase in taxes or a reduction in government expenditure) might actually be beneficial for the resolution of a debt crisis because it accelerates the turnaround in the current account.

Another corollary of the view that it is the foreign debt which matters is that the price of credit might be underpriced in countries in a balance-of-payments crisis. Experience and the empirical evidence presented here suggest that the supply of foreign funds is not a smoothly increasing function of the interest rates. Beyond a certain point, risk premia rise abruptly and finally credit rationing might set in. The cost of foreign funds to the entire country (and the danger of a systemic crisis) is thus likely to be related to the amount of external debt of the entire country (government plus private sector). This would suggest that the cost of capital is mispriced in EMU countries subject to (or simply in danger of) a balance-of-payments crisis and that there exists an externality: each individual (household or firm) will try to obtain as much credit as possible given his/her own path of income (and inter-temporal preferences). However, as argued here, foreign creditors will look at the country in the aggregate, given that they expect that, in a crisis, the government will in the end be responsible for all private debt as well.13

During a financial crisis the private debt accumulated during the preceding boom is usually transformed into public debt. But here again it matters whether the private debt was domestic or foreign. If the private debt accumulated during the boom was owed to foreigners, the political pressure on the government to socialize it is much lower. The cases of Iceland, Ireland, and Cyprus provide illustrations of this mechanism. In the case of Iceland, in October 2008 the parliament quickly passed an emergency law under which the domestic debt of the Icelandic banks (mostly deposits held by Icelanders) was effectively guaranteed by the state, but the foreign debt was not. The Icelandic banks sim-ply defaulted on their bonds, which were overwhelmingly held by foreigners. In Ireland, the government had intended in 2010 to allow its major banks to default on their so-called ‘senior unsecured’ bonds, which were held mostly by foreigners. This did not hap-pen only because of a strong intervention by the ECB (and other European institutions). The case of Cyprus is similar to that of Iceland: the country obtained financial support

13 For quite some time the Greek government did not have access to financial markets and its debt was trading at a substantial discount implying a high risk premium. But the lending rates applied by Greek banks to households and firms were much lower than the interest rate on government bonds. A similar situ-ation (cost of bank credit < cost of capital for government) could also be documented for other peripheral countries.

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from the IMF and the ESM in early 2013 in the context of a package of measures to restructure its two major internationally active banks. Under this package the holders of large deposits at these two banks suffered large losses, whereas small depositors (those below €100,000) were protected. This was again motivated by the fact that most small depositors are residents, whereas most large deposits were held by foreigners.

The distinction between foreign and domestic debt is thus relevant not only for exist-ing public debt, but also for all the private debt, which, potentially, could become public.

Appendix I: Robustness check on correlation between risk spreads and measures of external indebtedness

Table A1 provides two measures of the strength of a correlation for eight different cases: the (adjusted) R2 from a bivariate, cross-country regression and the p-value that the slope coefficient is equal to zero. In the regression the dependent variable was the square root of the spread (in the four variants shown in the first column of the table), and the independent variable the two different measures of foreign debt used here. It is apparent that in all cases the p value is extremely small, indicating that the likelihood that the correlation resulted from chance was less than 1 in 1,000.

Appendix II: An illustrative model: of the pricing of foreign debt with domestic financial institutions

The model has a country with a (public) debt equal to one. The ability of the gov-ernment to service this debt in full depends on the growth prospects of the country. This is also embedded in much market commentary which emphasizes that peripheral euro-area countries will be able to service their debt only if growth picks up soon. But growth is not certain.

Here it is simply assumed that with probability of (1 – p) growth returns at a sufficient pace so that with probability 1 – p the government will be able to repay its creditors in full in the next period (resources available for creditors > 1). In the other state of the world (low growth with probability p), the resources available for creditors are equal only to q, with (q < 1). The parameter (1 – p) can thus be thought of the growth pros-pects of the country.

These assumptions imply that with probability p the country will go into default and the sum available for debt holders will then be only q, which is less than the full face amount of the debt.

Table A1

Cumulated current account balance Cumulated net lending

Spread June 2012 0.635 (0.0002) 0.616 (0.0003)Spread January 2013 0.723 (0.0000) 0.723 (0.0000)Spread average 2010–13 0.670 (0.0002) 0.621 (0.0003)Peak in spread 0.584 (0.0006) 0.558 (0.0008)





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The price (value) of public debt (as a proportion of its face value) will then be given by:

pv p pq p q= −( ) + = − −( ) <1 1 1 1

where (1 – q) represents the loss (the hair cut) private creditors have to accept in case of default.

It is assumed that there are only two classes of investors in public debt: foreign and domestic. Domestic holdings of public debt are assumed to go through the national banking system. However, banks are highly leveraged institutions. They have to hold capital equivalent to less than 10 per cent of their assets. It is thus clear that any large loss on the holdings of government debt could make the domestic banking system insolvent or at least undercapitalized, thus leading to a domestic credit crunch. This is why in all debt restructurings banks are usually protected from losses. But if banks can-not take losses somebody else, i.e. the foreign investors, might have to take more. This question is thus: how would the holdings of government debt by domestic financial institutions which must be protected against losses influence the equilibrium market price of public debt (for foreign creditors)?

If there cannot be any ‘involvement’ of domestic financial institutions, the amount of resources available to foreign creditors is reduced. Let s denote the proportion of public debt held by domestic banks. This would imply that in case of a default only a propor-tion of the total public debt, given by 1 – s, can be subject to a loss whereas a proportion equal to s has to be repaid in full.

It follows that in the case of default the distribution of the amount available for foreign creditors of the country is the following: the domestic financial institutions are fully reimbursed (they receive s) and only the remainder goes to the private creditors, i.e. q – s (assuming q > s).

Keeping in mind that the foreign debt outstanding is equal to 1 – s; the (expected) value of foreign debt to foreign bondholders (as a proportion of its face value) is given by:

pv p p

q ss

pqs

= −( ) + −−

= − −−

11

111

.

The value of foreign debt thus falls as the share of de facto senior debt (the debt held by domestic financial institutions) increases. This equation illustrates what common sense would suggest: as s goes towards q (the domestic financial sector gets the entire resources available in case the bad state of the world materializes) foreign creditors receive nothing. The value of foreign debt then goes towards 1 – p, i.e. the probability of the good outcome under which the foreign private creditors receive full payment.

This might explain why the price of Greek and other bonds had to be so low just before the default, i.e. when the probability of the good outcome was close to zero: the recovery value for the foreign creditors was very low given that a substantial share of Greek public debt was held by Greek financial institutions—which in the end were protected from losses on their portfolio of Greek government bonds.

As long as q > s the value of the debt remains at 1 (full face value) for domestic banks because they can expect to receive the full face value under all states of the nature. Of course if q < s, i.e. if tax revenues in the bad state of nature are so low that they are not sufficient even to pay domestic financial institutions in full, there would have to be a haircut even for them.

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The reason why domestic financial institutions are usually spared a haircut is that if they had to accept large losses they would go bankrupt and this would further depress the economy, thus reducing the tax revenues available for debt service. But depending on the capitalization of the banks and the amount of debt they are holding, the impact on banks’ balance sheets and their ability to continue lending to the real economy might be more or less strong. This idea can be formalized by positing q (the amount of tax revenues available in the bad state) as a function of the haircut for domestic banks, denoted by h:

q q h= ( ) with q(0) < 1, q’ < 0 and q’’ < 0.

This implies that the price of debt (to foreign creditors) can be written as:

pv p pq h s h

sp

q h sh

s= −( ) + ( ) − −( )

−

= −− ( ) −

−1

1

11

1

1.

In this more general case the link between the value of the debt and the proportion of debt held by domestic financial institutions will be influenced by the haircut imposed on the latter. The limiting case of no haircut on domestic debt (h = 0) was already considered above. It is clear that in this case, i.e. if the domestic banking system is so robust that that it could take a substantial haircut on its holding of government debt, the value of the debt held domestically would no longer remain at the full face value. It would be given instead by:

pv p p h ps h

sb = −( ) + −( ) = −−( )−

1 1 11

1

where pvb denotes the present value of debt for domestic banks. As domestic banks are unlikely to actively trade in the debt of their own sovereign once it has become distressed, this is not a price that one could observe on a market. But in principle this is the price at which it should appear in their balance sheets.

Comparing the two last equations shows that the value of the debt for domestic financial institutions will naturally be higher than that for foreign holders (of course only as long as the haircut imposed on domestic banks is lower than the decline in tax revenues in the bad state, i.e. as long as h < (1 – q).

The marginal impact of a higher haircut (h > 0) on the market price of debt (or the price at which foreigners would be willing to acquire it) would be given by:

∂

∂= +

−

priceh

pq s

s

′

1.

The haircut which maximizes the payout for foreign creditors, h*, is thus given by q’(h*) = –s.

Given that q’’ is negative, this implies that a higher proportion of debt held by domes-tic financial institutions should lead to a higher haircut on the debt held by them.

An illustrative special case of q(h) would be q q h= − ∝( )1 2 .In this case the haircut on domestic banks which maximizes the value of the remain-

ing (mostly foreign) debt would be given by:

s q h= ∝2 .





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In this case a higher share of debt held by domestic financial institutions would lead to a proportionally higher haircut (should the bad state of nature material-ize). The (expected present) value of the debt for foreign creditors would then be given by:

pv pq s q

s* = −

− − ∝( )−

11 4

1

2 /

which is higher than in the case when there cannot be any haircut on domestic creditors. The existence of a strong domestic banking system can thus reduce the risk premium for foreign creditors if the default is organized in such a way as to minimize the losses for them.

The general result remains that, ceteris paribus, the higher the share of government debt held by domestic financial institutions the lower the price of debt, or, equivalently the higher the risk premium demanded by the foreign creditors.

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