Sub-sovereigns: the next restructuring trend?
Central governments have been passing the debt buck to their regions and municipalities for decades. There could be trouble in store.
The vast debt some sovereigns have taken on since the era of cheap borrowing began has been a concern of economists for some time. The issue came to the fore once again in June when Argentina successfully sold $2.75 billion of 100-year debt, attracting demand of nearly $10 billion.
This is, after all, a country that has defaulted eight times in its 200-year history. Even if Argentina’s debt levels are currently sustainable, there is reason to raise an eyebrow, at least.
But sovereigns, including Argentina and Greece, have gone through painful restructurings already. If you believe in the adequacy and sustainability of their fiscal plans, taking a long-term punt can be lucrative. And as long as the base-case scenario of improving global growth remains the base case, why shouldn’t sovereigns fund themselves at historically rock-bottom rates?
Meanwhile, sub-sovereign, quasi-sovereign and state-owned enterprises in many jurisdictions have been asked to take on more of their own funding responsibilities in recent decades. And, facilitated by low rates, they have been able to fill themselves up.
But some sub-sovereigns and other public and quasi-public entities have been borrowing like first-time credit-card holders with an implied backstop from the Bank of Mum and Dad.
It may well be that it is here, in the sub-sovereign sector, where the next wave of restructurings will occur.
One of the more notable examples of how sub-sovereign borrowing can go disastrously wrong was the Austrian Province of Carinthia’s exceedingly complicated €10.9 billion cancellation of contingent liabilities through a debt buyback last year.
Creditors in that case were given an explicit guarantee by the Province of Carinthia – one that turned out to be worthless, despite the wealth of its residents. What followed was about as close to a soap opera as the debt markets get, with Carinthia submitting an offer to creditors without consulting them first (rejected) before a solution was finally worked out.
It was a unique case – in some respects. Carinthia’s annual budget was €2.2 billion – about a fifth of the value of the bonds it guaranteed. And other debt with the same provenance (the failed bank Hypo Alpe Adria) was guaranteed by the Austrian government, which refused to honour Carinthia’s guarantees on its behalf.
Matthieu Pigasse, head of the public sector group at Lazard, (which wins this year’s award for world’s best bank for public-sector clients and advised Carinthia on this case) says sovereigns have been increasingly decentralizing and devolving certain responsibilities to sub-sovereign entities. “Maybe two three years ago, we were mainly focussing on governments and public clients, including sovereigns and central banks,” Pigasse says. “More and more, we are dealing with either local authorities and entities or state-owned entities – not governments.” That is where Lazard sees a good deal of future business being done. The firm is advising the Ukrainian city of Kiev on a fiscal overhaul and helping the International Bank of Azerbaijan to restructure $3.3 billion of debt through a sovereign debt exchange. Investors have also become increasingly jittery over state-owned enterprises in China, where state guarantees were often thought to be implicit, until defaults began to spike in 2016.
However, it is in Europe where these kinds of problems are likely to arise in force next.
“If you take Europe: in the last 20 to 30 years, governments there have delegated a lot of their missions to public companies, local entities, semi-public entities like public-private partnerships,” says Pigasse. He also expects to see more cities in Europe, as well as state energy and infrastructure enterprises, begin to struggle.
A paper from the European Central Bank published in December doesn’t give much reason for optimism. Its authors found that investors sometimes demand lower risk premia for debt from sub-sovereigns with debt-to-GDP ratios above their federations (the study focuses on federated states).
They conclude that is because investors think small sub-sovereigns could be supported by the central government or federation, should things go awry. Larger sub-sovereigns pay higher premia as their debt levels rise because investors figure they are ‘too big to be rescued’.
As ever, investors tend to scrutinize investment fundamentals much more closely as things fall apart: Lehman, Bear Stearns, Banco Espírito Santo, etc. Abstruse and complicated exposures only tend to be thought of as part of the picture once the picture begins to crack.