The ESG movement has made some good points about how professional investors should evaluate companies. It can help understand future price movements if the analysts have done their homework on how a company treats its employees, considers the neighbours, lightens or darkens its touch on the environment and conforms to rules of honest and decent behaviour.
These issues matter in themselves and may well influence share prices. A badly run company is more likely to damage itself by sudden disclosures or bad treatment which can go on to have a major cost to shareholders. These same considerations are also applied to the analysis of company debt for obvious reasons.
The next question to ask is does any of this apply to state debt?
There is a tendency in investment for people to see so-called sovereign issues, issues of debt by governments, as much safer than other forms of financial investment. The argument runs that most governments most of the time honour their debt obligations.
Where a company can run out of money to pay shareholder dividends or even to pay interest on borrowings, a state has access to money in two additional ways which make it more likely they can pay. The state can always raise more money from taxpayers in difficult times. The state owns the central bank and money-creation systems, so it can always create more money to honour nominal debts. This may cause a bit of inflation, but the state can say it has met its legal requirements to repay in its own currency the amount borrowed any time it likes by simply creating the cash.
These special powers of a state no longer apply to Euro-area countries, as they no longer control their own central banks and money creation. Purchasers of Italian or Greek debt need to understand that is not the same as buying the debts of a country that controls its own currency. Greece did fail to pay its debts on time in the last decade and needed restructuring and forgiveness to get by. We need also to ask whether there are other warning signs or concerns that mean some states will not repay their debts in full or on time even when they have the power to tax and to print money.
This is where ESG-type questions can assist. Some of this has long been done by credit analysts, but ESG tells us to look more widely for things that could go wrong for any given borrower.
States do default
Over the last half century or so there has been a risk of default by certain South American and African countries that have overstretched and borrowed too much. Usually borrowing abroad is a major cause of added pressure, as borrowing in a foreign currency cannot be met by printing more of your own money. Any attempt to inflate out of debt causes a run on the domestic currency and makes the foreign debt dearer. Some of the problems stem from simply printing too much to meet domestic debt schedules, triggering high inflation which can only be stopped by reneging on debt and rebasing the currency.
Maybe we also need to take account in the ratings of overseas government paper issues of governance. The ESG movement may become more concerned about future liabilities of governments that have not made good progress on the road to net zero or to living better with nature. This might catch up with them and present that state with large bills later to remedy the problems. Should there be more rating of governments around the criteria of human rights, rule of law, financial record and environmental actions? Bad behaviour on these issues can put off world investors and make it more difficult for such countries to raise money and keep up their credit rating.
In recent years we have seen defaults by Argentina, Venezuela, Puerto Rico and Sudan. The Bank of England tells us that, since 1960, a stunning 147 governments out of 214 have defaulted or failed to pay on time. This can also affect major rich countries. Germany defaulted in 1932 and in 1948 to recover from the damage of the war. Iceland defaulted in 2008.
Investors need to be aware that not all sovereign bonds are low risk, and not all deserve the accolade of a price premium, which means you get less interest on them than on other investments. If anyone tells you a bond is lower risk because it is a sovereign credit you do need to test whether it is genuine sovereign with the effective powers to tax and print. Today, you also need to ask whether, despite that, you could end up with an expensive investment that the country undermines by bad governance and a failure to meet its wider international legal, social and environmental obligations.
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