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Wednesday, April 4, 2012

Who should finance what?

Two issues on which I have published before are:

(a) bond financing vs. loan financing, and
(b) raising public financing domestically or internationally.

Let’s just assume that all of Greece’s sovereign and other foreign debt had been held by banks in the form of loans. That would have been a rather simple affair, basically a “family affair”: have the banks elect a Steering Committee and negotiate with it. There would have been no vulnerability regarding the type of things one can do with public debt instruments (hedge funds, etc.). One would have known all the counterparties and every counterparty would have had something at stake – not only its loan but also its standing in the financial community (and in the loan syndicate).

Let’s also assume that all of Greece’s sovereign debt would have been financed domestically. From a liquidity standpoint, that would have been possible because there was enough liquidity in the Greek banking system to finance that portion of the sovereign debt which ended up on the books of foreign financiers. In that scenario, Greece would not have had to negotiate with all sorts of smart speculators worldwide but, instead, only with its own citizens.

The route of bond financing is normally chosen to open a broader market of investors. That was not the case in Greece because most of Greece’s sovereign debt was/is with institutional investors who could also have been included in a syndicated loan. Thus, that particular benefit of bond financing did not generate any significant added value for Greece.

The question of whether sovereign financing should be raised domestically or internationally is something which should be debated going forward.

My position is that the regular budget deficit should be financed exclusively domestically. The “regular” budget includes the expenditures out of the ordinary course of business. If a society cannot afford its expenditures out of the ordinary course of business, it should cut them. Why should foreign savers finance the ordinary expenditures of a society when domestic savers are not prepared to do that?

I take a different view on government investments. First, they are not “expenditures” and, secondly, their size often exceeds the resources of a national capital market.

When foreigners provide financing for the general budget, they have very little idea what their funds are really used for. Sovereign risk is something very difficult to assess. When foreigners provide financing for investment projects, they can assess the risk much better.

So who is going to finance the economy when the public sector sucks up all domestic liquidity for its own purposes (“crowding out”)? Well, the economy will raise such financing domestically and/or abroad. Private sector risks (corporations, projects) are much easier for foreigners to assess than sovereign risk. There is no reason why the economy should not take advantage of all the foreign funding it can get. Incidentally, only large corporations are able to finance themselves internationally. The rest of the economy will receive its financing from domestic banks which, in turn, borrow internationally.

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