There is a narrative going around in Malaysia that a government which has a majority of its debts denominated in a local currency can never default on its borrowings. For the purpose of clarity, it is the case where a national government has control over both its fiscal and monetary policy.

I have trouble with that narrative. In case of locally-denominated government bonds, it does certainly make default less likely than the case of foreign-denominated borrowings. But, that is of no guarantee of no-default.

A government for instance can certainly refuse to service its debts even if it is more than capable of fulfilling its obligation. Outright refusal happens very rarely and this is world, it is probably an absolutely disastrously crazy thing to do but I only highlight it to show that a government can default at any time and in this case, voluntarily. The debate about the debt ceiling the United States is an example of voluntary default; without further borrowings, the United States may have to default on its loans payment although it definitely can close down some of its government services before having to resort to defaulting.

Notwithstanding voluntary default, in the case of locally denominated government bonds as a sufficient condition for the outcome of no-default is dependent on the ability of the government to raise more debts to service its preexisting financial obligation when there is revenue shortfall. It depends on several matters. That includes the willingness of the central bank to monetize government debts, its willingness to commit seigniorage or the willingness of the private sector or anybody else which includes foreigners to purchase the government debts.

The most relevant factors to consider are the willingness of the central bank to monetize government debt or to commit seigniorage (money printing).

A fiercely independent central bank can easily refuse to do both, especially when the central bank has a commitment to price stability. In normal times, debt monetization and seigniorage do contribute to inflation in a big way. Without the central bank and without the power of a monetary authority, the government will default.

So, the truth is that a government cannot default of its locally-denominated debts if the central bank cooperates with the government. And if the central bank does decide to cooperate, there is cost to that cooperation.

In talking about that no-default guarantee especially within Malaysian context which both sides of the political divide do misrepresent and wrongly contextualize economic issues in supporting convenient political positions, the cost of the no-default scenario is not discussed.

One Response to “[2670] Be careful with the no-default narrative”

  1. on 18 Mar 2013 at 09:07 hishamh -importance-of-printing-your-own-currency.html

    A slightly different perspective on the debate, one I wan’t aware of. Neither monetisation nor financial repression are optimal – I still think the practical and sustainable limit to government borrowing is always going to be the expected output gap.

Trackback URI | Comments RSS

Leave a Reply