ABC of debt
Public Debt Mini Academy, created by Civil Development Forum and “Metro” newspaper.
Every Polish citize would have to pay more than 25 thousand PLN to make our public debt disappear. The author of Polish economic reforms, Prof Leszek Balcerowicz, has been urging to reduce the indebtedness, and a Public Debt Clock runs in the center of Warsaw.
What’s with the debt? From whom does our country borrow? Can Poland go bankrupt and what would happen then? Economists of Civil Development Forum answer these and many other questions in Public Debt Mini Academy, published also in “Metro.”
The major problem is its rapid growth as the higher the debt, the higher the cost of its servicing. If investors began to perceive Poland as a country that in the future may have problems with repayment, it would be difficult for us to find buyers of our bonds. Hence, we would continue indebting but on worse conditions (higher interest rate) than now.
If the public debt stops growing and stabilizes on its current level that is app. 50 % of GDP then -given opportune conditions – it would be rolled over* ceaselessly. But such situation has its price – in 2014 alone the cost of servicing of the public debt was 33,5 billion PLN. And it is the cost for one year only! That is why the debt should be reduced.
* To roll over a debt – to buy off issued bonds when their payment is due not with the money from savings but from a new debt.
We must differentiate between the sector of public finances and the budget. Public finances besides state government’s budget, include local governments’ budgets and various kinds of non-budgetary funds, that the largest is FUS (Social Security Fund). Thus, the public debt is the sum of the debts of state and local government and the funds. At the end of 2014 the public debt (according to national definition) was app. 827 billion PLN of which 755 billion PLN was generated by the state government, 72 billion PLN by local governments and 0,12 billion PLN by FUS.
Our national definition of public debt is slightly narrower than that of the European Union. Eurostat (the statistical office of the European Union) includes in its definition of public debt, for example, obligations incurred by the National Road Fund. At the end of 2014 the public debt according to the national definition was 827 billion PLN (48,1 % of GDP) whereas according to the EU’s methodology was 867 billion PLN (50,4 % of GDP).
Budget deficit is the difference between government’s revenues and expenditures in a given year. Budget deficit is a part of the public finance deficit, which also encompasses deficits of local governments and non-budgetary funds (e.g. FUS). Every year the public debt grows by the portion of the budget deficit, which is financed by credit (emission of bonds and treasury obligations) rather than revenues from the sale of public assets.
The smaller the debt (the public debt is the total of all government borrowings) and the deficit (deficit of the public finance is a difference between the expenditures and the revenues of the central and local government and public institutions in a given year), the better. It is hard, however, to provide concrete values. In 2010, Romania and Latvia were on the verge of bankruptcy and had to receive the international aid (from the International Monetary Fund and the European Commission). Romania’s public debt that year was 29,9% of GDP while the deficit was 6,9%.
The respective values for Latvia were 47,5% of GDP and 8,5 % of GDP. At the same time, Great Britain without any problems was borrowing money to finance its deficit which in 2010 was 9,7% of GDP and the debt amounting to 76,6% (nevertheless, the discussion about the restoration of public finances continues). Where does this difference come from? Great Britain is one of the most developed countries in the world, which has been repaying its debts regularly for the past several hundred years (the last time the UK restructured its debt in the 80s of the 20th century). On the other side, Latvia is relatively poor country, which has only been on the map of Europe for only 20 years. Romania’s creditworthiness is not much better – the country did not pay its foreign debt in the years 1933-1958, 1981-1983 and in 1986.
Additionally, the perception of “safe” level of debt and deficit is changing.
Before the financial crisis investors were eagerly buying Greek bonds and they were not discouraged by the fact that Greece’s debt was hovering around 100% of GDP. When the financial crisis broke out, investors became more nervous, the Greek deficit rose and the country stood on the brink of bankruptcy.
Before we begin to repay the debt, first we need to slow and eventually halt its rise. In the past, a few countries managed to stop the growth of indebtedness and in effect to considerably lower their debt to GDP ratio.
Poland can take an example from:
- Chile, which in 1989-1998 reduced the public debt from 46,2% to 12,9% of GDP. For more than half of this drop was responsible the reduction of the public finance deficit, while the rest was accounted for the GDP growth.
- Turkey, which in 2001-2007 reduced the public debt from 77,6% to 39,4% of GDP. Almost 70 % of this reduction was achieved by lowering the deficit (mainly by raising taxes), while 30 % came from the GDP growth.
- Bulgaria, which in 1996-2007 reduced the public debt from 96,4 % to 18,7% of GDP. Half of this drop was a result of lowering the deficit (mainly from cuts in spending), and the rest from the GDP growth.
- Republic of South Africa, which in 1998 – 2008 reduced the public debt from 57,2% to 22,5%. In that case, the most significant was the rapid growth of the GDP, however, the cuts in spending also played a crucial role here.
The analysis of the experiences of countries that had the largest public debt reductions in relation to GDP allows to form general conclusions. Firstly, in developing countries, more than a half of this improvement resulted from the rapid growth of GDP, whereas a 1/3 resulted from the reduction of the public deficit. Secondly, a steady decline of the public finance deficit resulted on average in 70 % from a reduction of public spending, while in only 30% from raising taxes. Thirdly, in developed countries almost entire reduction of the public debt to GDP ratio resulted from a decrease in the public finance deficit, which was in equal measure was caused by cuts in spending and by tax increase.
Yes. At the end of 2014 the public debt was 827 billion PLN, of which 472 billion is held by foreign investors. The remaining 355 billion PLN was a debt to the national financial institutions and individual investors. It is worth noting, that foreign investors not only buy treasury bonds denominated in foreign currencies but also treasury bonds denominated in the Polish zloty. In effect, at the end of 2014 the foreign debt of the public finance sector was almost 180 billion zloty larger than the indebtedness of the country resulting from emitted bonds and credits drawn in foreign currencies.
The foreign debt of Poland is not only made of public debt owned by foreign entities, but also the private debt of the Polish citizens and Polish companies in foreign currencies. Apart from the public debt owned by foreign entities, Poland had additionally the foreign debt of 550 billion PLN, of which:
- 399 billion PLN were debts of banking sector
- 20 billion PLN were borrowed by National Bank of Poland
- 1055 billion PLN were borrowed by Polish citizens and companies
More than half of the public debt was generated in the last 15 years. In 2000, the Polish public debt was 370 billion PLN (in fixed prices as of 2010), and by the end of 2014 it was 776 billion PLN.
Commonly we refer to bankruptcy of a country when it is not able to repay its debt on time. As opposed to entrepreneurships for which bankruptcy means disappearance from the market (closing of a company), nowadays bankruptcies of countries do not imply their liquidation. Governments have the right to levy taxes to pay off outstanding debt, however, usually it means longer repayment period than originally planned. That is why it is more appropriate in case of countries, that have problems with a debt servicing, to refer to their loss of financial liquidity or temporary insolvency.
Losing liquidity or country’s default is significantly determined by country’s creditors. For example, in mid-2010 the national public debt of Poland was 827 billion PLN, of which 535 billion PLN was the debt incurred in the Polish currency while 292 billion PLN in foreign currencies. In reality, our liabilities toward foreign investors were much higher because aside from currency bonds they also owned 180 billion PLN in bonds denominated in Polish zloty.
A country can suspend a repayment of a debt denominated in national or foreign currency. In the first case, it is easier for governments to pay back by allowing higher rate of inflation. This is how the real value of the debt is lowered. However, the brunt of such operation is taken by all investors that bought bonds in national currency, and all citizens in possession of cash. A country that suspends repayment of the debt has to be aware that in the future investors will avoid investing there as who would like to invest in a country that does not pay its debts. Such country may also have problems with concluding international agreements. Also, country’s entrepreneurs will have problems to take foreign loans.
Countries that have problems with paying off its debt try to restructure it. Usually it means a longer repayment period, a temporary aid from other countries or international institutions in order to obtain further loans (e.g. at a lower interest rate) or a possible cancellation of a part of the debt.
Public debt may bring countries to bankruptcy in a various ways. First of all, we must differentiate between bankruptcy through internal public debt (in simple terms: a debt owed to citizens of a country) and through external public debt (in simple terms: a debt owed to foreign investors).
In 1990-2009 the countries that went bankrupt:
- through external public debt:
Argentina (2001), Republic of Côte d’Ivoire (2000), Ecuador (1999 and 2008), Indonesia (1998 and 2000), Kenya (2001), Myanmar (1997), Nigeria (2001 and 2005), Paraguay (2002), Russia (1998), Turkey (almost went bankrupt, aid from IMF in 2000), Uruguay (2003), Venezuela (1995 and 2004), Zimbabwe (2000).
- through internal public debt:/
Argentina (2000), Argentina (2007), Ecuador (1999), Angola (1992), Russia (1998), Sri Lanka (1996), Venezuela (1998), Zimbabwe (2006).
The shorter list of the bankruptcies through internal debt does not mean that they are fewer. They are simply poorer documented. Information about external debt bankruptcies draws attention of international financial institutions. While in case of internal public debt governments often resort to allowing a higher rate of inflation what in effect lowers a real value of the debt and it is easier to pay it. Thus, although it cannot be called a bankruptcy, in fact the result is the same – creditors receive less than they lent.
It is worth mentioning that there were several countries which during the latest world financial crisis asked for aid from the International Monetary Fund and other international institutions (e.g. European Commission) what saved them from going bankrupt. Among them were:
• Angola (in 2009), Antigua and Barbuda (2010), Bosna and Herzegovina (2009), Dominican Republic (2009), Salvador (2010), Georgia (2008), Greece (2010), Guatemala (2009), Hungary (2008), Iceland (2008), Iraq (2010), Jamaica (2010), Kosovo (2010), Latvia (2008), Maldives (2009), Mongolia (2009), Pakistan (2008), Romania (2009), Serbia (2009), Sri Lanka (2009), Ukraine (2008).
There are a few countries like that. From 182 countries evaluated by the International Monetary Fund, only Hong Kong practically did not have public debt. The top 10 countries with the lowest level of public debt are mainly oil countries. However, it is worth noting that among them there is Estonia that do not have any natural resources that would facilitate financing the debt, yet its low public debt is a result of good economic policy. There are two non-oil countries with low public debt to GDP ratio: an Asian economic tiger, Hong Kong and Estonia. This last example proves that post-communist countries of the Central and Eastern Europe are able to avoid indebtedness of public finances sector even during economic downturn.
|Country||Debt (% GDP)||Characteristics|
|Hong Kong SAR||0%|
|Brunei Darussalam||3%||oil & gas|
|Saudi Arabia||7 %||oil & gas|
|Oman||9 %||oil & gas|
|Kuwait||10%||oil & gas|
|Algeria||10%||oil & gas|
|Uzbekistan||12%||oil & gas|
|Nigeria||12%||oil & gas|
Source: International Monetary Fund, World Economic Outlook Autumn 2015
The most common source it is their citizens.
Every Polish person who buys treasury bonds lends money to the government. Moreover, this debt will be paid back with his/her own taxes. This means that the more a state borrows, the more taxes it has to lay. If a government systematically rises the public debt, the next generations have to pay it off. A statistical Pole may not even know that he/she lends the money to the state. It suffices that his/her market-based pension fund (OFE) buys treasury bonds.
In Poland the public debt is mainly financed by Polish citizens. In mid-2010 the public debt was 827 billion zlotys, whereas 355 billion PLN was the money owed to so called residents – Polish companies and citizens. The remaining 472 billion PLN was what Poland owed to foreign investors.
Public debt structure is a subject to strong differentiation. Some countries borrow mainly from their citizens (Japan, Italy), others mainly from foreign investors (Portugal, Greece). If Greece or Portugal suspended their repayments, big financial institutions that have purchased a lot of their bonds, would lose significant amount of money (e.g. German banks).
First of all, the growing debt is also a matter of concern of the public opinion, politicians and economists in the Western Europe. The British government is implementing the austerity program that is to bring down the Great Britain’s public finance deficit from over 10% to 2% of GDP in 2010-2017. By 2015 almost 1 million workers on the government payroll lost their jobs. Germany included in their constitution a prohibition of further incurrence of debt (will come to effect on federal level in 2016, on the level of Lands in 2020). Even France has begun to save by increasing slightly the retirement age.
Secondly, the Western countries are not only richer than us but also more trustworthy for investors in the financial market. It would be more advisable to compare Poland then with other countries in the region that have a similar GDP per capita.
In such ranking, Poland does not look good, and according to forecast by the European Commission for 2015:
- The higher public debt to GDP ratio will have Croatia, Slovenia, Hungary and Slovakia, however, all remaining countries will reach significantly lower level of the public debt than Poland, e.g. Czech Republic 41% of GDP.
- Higher public finance deficit is only forecasted for Croatia and Slovenia.
Thirdly, Poland is still on the rise. The high level of the public debt slows down the development of Poland, and in effect, hinders us from catching up the gap between Poland and the developed countries. Instead of spending public money on, for example, highways and education, we pay 1,8% of GDP (a forecast of the EC for 2015) only on debt interest. Today Poland pays to bonds’ owners one of the highest interest rates in the European Union. Besides, the country’s growing debt limits the amount of funds that financial institutions allocate for investments and business loans. In effect, high public debt obstructs private investments in the economy, what also slows down Poland’s development.
According to the methodology of the European Union, the Polish public debt by the end of 2014 was 867 billion PLN (50,4% of GDP). However, according to the Polish definition it was 827 billion PLN (48,1% of GDP). The latter methodology is used to apply to the constitutional limit of debt, the cautionary threshold and the stabilizing spending rule. Where does this difference come from?
The Polish government and the European Commission have different definitions of public debt. The key difference is the classification of National Road Fund (NRF), that according to the EC it is a part of public finances while according to the Polish government it is not. Unfortunately, the European Commission is right – debts incurred by the NRF are paid off by the Polish taxpayers. Besides, the Polish government somewhat agrees with the European Commission and always calculates the debt according to both the EU and the national methodologies. So why all this confusion? The national methodology was designed only for the reason of avoiding the risk of crossing the cautionary threshold of 55 %, which obligates the government to implement tangible and mandatory savings (i.e. freezing public sector wages, raising pensions and welfare payments only according to inflation). Since savings are not popular, the government prefers to change the definition rather than start to save.
The history of country bankruptcies is a vast topic. France alone in the years 1500-1800 bankrupted eight times. The reasons of bankruptcies sometimes were very mundane. For example, Spain declared bankruptcy in 1628 after their Silver treasury fleet, that transported silver and gold from American colonies to Cádiz, was defeated and captured by the Dutch. Interestingly, Spain six times declared bankruptcy in the 16th and 17th century despite the fact that the conquest of Aztecs and Incas made Spain the richest country in Europe.
In Middle Ages and at the beginning of the early modern period bankruptcies had bloody consequences. For example, French kings often cancelled their debts by having their main creditors beheaded. French kings also robbed their subjects in a more deliberate way. In the Versailles Statement from 1706 we read: “(…) Being certain that we will not be able to meet this challenge of financing the war without further borrowing, instead of imposing a new burden on subjects, we introduced paper money (…)”. In other words, Luis XIV financed the war simply by printing money.
Unpaid debts were also a cause of military interventions, among many in Egypt in 1880, in Venezuela in 1902, in Dominican Republic and Nicaragua in 1905. Liquidation of a country is considered to be an extreme case as of Newfoundland in 1934. When this democratic country with the status of the dominium of the British Empire was not able to service its debts, it gave up its self-governing status to London, that later in 1949 decided Newfoundland would join Canada as its tenth province.
The decrease of public debt to GDP in 2014 (according to the national methodology: 54,3% to 48,1 %, and to EU: 55,9% to 50,4%) was only apparent as it depended on accounting method. This is when a part of the official public debt was transferred to the hidden debt under the so- called OFE reform (Open Pension Funds) implemented by the Donald Tusk’s government.
Total public debt is the sum of official debt that is covered by treasury papers, and the debt hidden in the pension system. Poland’s pension system introduced in 1999, based on defined contribution, does not generate a debt because benefits strictly depend on actually paid contribution by a pensioner. The debt, however, has been continuously caused by the former system based on defined benefits which means that pensioners receive their pensions regardless an amount of funds contributed. In the new pension system contributions are paid to ZUS (Social Security Institution) or to ZUS and OFE. When a person makes a contribution to its individual account in OFE, he/she receives investment portfolios and such accumulated capital will be used in the future to pay old-age pension benefits. In case of ZUS, a person receives only the Social Insurance Institution’s commitment that he/she will receive benefits equal to paid contributions. This obligation that ZUS makes is a part of the hidden debt. That is why funds paid to ZUS can be used for payment of current pensions of the old system, but funds from OFE cannot.
In 2013 under the so-called OFE reform, the government of Donald Tusk reduced a part of contribution to OFE and pushed majority of people out of the OFE system (Communique 31.07.2014), in effect every year they reveal less of the hidden pension debt than previously. Then in 2014 the government nationalized the privately held open pension funds comprised mainly of state treasury bonds that represented some of 50 % of OFE holdings. The sum was credited to the accounts of pension savers in ZUS. At the same time the official public debt was reduced to apply to the constitutional limit of debt, the cautionary threshold, the stabilizing pending rule and the European treaties. Yet the hidden debt, that will have to be paid in the future, proportionally grew. It was argued, falsely in opinion of FOR, that without the pension overhaul there would be risk of exceeding the threshold of 55 % of GDP in 2014 (Analysis No. 03/2014), but it allowed the government to raise the expenditures in the election year (2015) instead of implementing the previously planned cuts on spending (Presentation as of 2.12.2013).
Contemporary Greece has almost always had problems with the public finances. Since its independence in 1830 statistically every two years it was at the verge of bankruptcy because of inability to pay off the debts.
Greece’s entry to the European Community (predecessor of EU) in 1981 was the award for democratic transformation, what was not accompanied by appropriate economic reforms. In effect, the public finances stability did not improve. This situation started to change at the end of the 90s of the 20th century. Greece’s access to the Eurozone was conditioned by decrease of the deficit to below 3% of GDP. Then investors became more trustworthy, as they believed in change, and they willingly lent the money. The profitability of Greek treasury bonds, that is the cost of the debt, decreased almost by half. Soon it turned to be an illusionary success due to the fact that their deficit figures from the end of the 90s were simply forged – the state revenues were highly overstated, whereas the expenditures were understated.
Moreover, when the world financial crisis broke in 2008, Greece was approaching new elections and nobody thought about austerity programs or raising taxes. Right after the new government was formed in 2009 it announced that the budget deficit would not equal 5,8 % of GDP, as had been previously stated by the former government, but 15 % of GDP. It was not only one reason but many, such as high public debt (app. 100% of GDP), the disastrous Greece’s reputation that was the consequence of manipulating the national statistics and lack of reforms, that caused that nobody wanted to loan money to Greece. Few investors willing to buy Greek bonds expected very high interest that was to recompense the risk they bore. At the same time when the German government could borrow at 3 per cent per annum, nobody wanted to loan money to Greece at lower interest rate than 8%. The growing costs of servicing the debt made it only worse. When Greece was veering toward bankruptcy, the International Monetary Fund and the European Community came with the aid. In 2012, however, Greece de facto bankrupted and private bond-holders had to accept a reduction of the nominal value of the bonds by half. Since that time Greece situation is uncertain. FOR published the analysis of the Greek crisis in 2010 (Analysis1/2010), in 2012 (Presentation 30.05.2012), and in 2015 (Communique 24.01.2015).