Investor fears that the bloated sovereign debt market is beginning to pose risks to the world economy could soon be exacerbated by an additional threat lurking in the shadows of government finance.
Since the financial crisis, a hidden pool of government-linked securities has emerged which, thanks to its hybrid status, has the potential to draw on national resources yet rarely shows up in national accounts.
Borrowers backed by the state, including cities, local authorities and fully or majority state-owned companies comprise a vast, and still growing, sector highly attractive to investors because of the implicit assumption that it will be bailed out in times of trouble.
Because the debt is not issued directly by the state it is not always included in official debt-to-GDP numbers. This means it is not included in analysis of a country’s solvency.
The government-sponsored enterprises were put into “conservatorship” at the height of the financial crisis but their debt was never absorbed into the US balance sheet because, the government said, the arrangement was temporary.
Eight years on the conservatorship remains in place but the obligations are still outside official federal debt calculated by the Department of the Treasury.
The phenomenon is not confined to the US. Mexican state-controlled oil company Pemex, government-backed Export Credit Bank of Turkey, the city of Paris, Sri Lankan Airlines and Germany’s development bank KfW are all part of the same group.
In emerging markets alone, JPMorgan estimates there is now $800bn of quasi-sovereign debt in dollars and other foreign currencies.
What they share is the benefit of a strong link to sovereign credit. Although not always backed by a legal guarantee, this link enables them to borrow money on markets at lower rates than other corporate debt issuers.
“This practice keeps the sovereign’s official debt ratio low, thus facilitating its continued access to future borrowings,” wrote the United Nations Conference on Trade and Development in a paper examining the sector last summer.
“Preliminary evidence suggests that, since the global financial crisis, sovereign contingent liabilities have grown exponentially . . . How these growing contingent liabilities may be included in sovereign debt restructuring is currently unclear.”
Charles de Quinsonas at M&G points out that spreads of quasi-sovereign bonds above their respective sovereigns have increased in emerging markets as concerns about corporate defaults rise. In Latin America the average spread hit 286 basis points in late 2015, compared with 98 basis points in Asia.
According to the World Bank, contingent liabilities are a source of risk in part because of the erratic way they are accounted for by governments.
In the UK, for example, the Office for National Statistics recently changed its mind over housing association debt, deciding it should be included in sovereign debt calculations.
Mexico includes state-owned energy company Pemex in its calculations, but not debt borrowed by local governments. Brazil’s partially state-owned Petrobras is not included in Brazilian debt-to-GDP figures.
Lee Buchheit, who has written on contingent liabilities along with Mitu Gulati at Duke University, says the variable accounting treatments allow some sovereigns to raise capital on the strength of their credit standing without visibly increasing the size of their stock of debt.
“From the sovereign's standpoint, the level of explicit support depends on what the market demands,” he says. “It’s only when default is looming and a sovereign starts to point that there is no actual guarantee that things can get ugly.”
Right now, this scenario is being played out in Austria, where the Alpine state of Carinthia is suffering the ill effects of offering collapsed local Hypo Alpe Adria bank a guarantee. Carinthia cannot pay, and investors want the Austrian state to stand behind the debt. Austria has refused.
“It’s interesting because sovereigns and quasi-sovereigns do not default very often so it becomes a theoretical exercise for investors to try to price that risk,” says Joe Kogan, head of emerging-markets strategy at Scotiabank, who has frequently written on the sector.
“In good times the spread between the two compresses but recently there have been specific problems at certain companies and spreads at places such as Pemex have increased.”
The Organisation for Economic Co-operation and Development points out that this can skew markets by encouraging investors to favour possibly weak issuers with a strong sovereign backer, which can then suffer sell-offs during periods of lower risk appetite.
Credit rating agency Moody’s says that possible weakness in quasi-sovereign borrowers is already having an impact on certain sovereign ratings in emerging markets.
Recently, it cautioned Malaysia that rising contingent liabilities were weighing on its credit profile.
“The key thing we look at is the likelihood that it will crystallise on the balance sheet,” says Anne Van Praagh, managing director of sovereign risk at Moody’s.
“There has been notable increase of this sort of debt. It is certainly an area that would benefit from far more transparency.”