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Here’s a tip for governments, including that of the United States, trying to maintain faith in their public debt during trying times: Borrow as much as you can from domestic investors. Investor confidence in a nation’s debt varies in proportion to the percentage owned by the country’s own citizens and institutions, concludes a recent report published by the International Monetary Fund.

The reason is simple, state the authors of “Strategies for Fiscal Consolidation in the Post Crisis World“:

Governments are generally more willing to honor debt held by domestic agents — who typically are either citizens with voting rights or systemically important institutions such as banks — as opposed to foreign investors.

Conducting a regression analysis of data from 60 nations, the study compared companies with a “low” share of domestic debt to countries with a “medium” share. A one percentage point increase in the debt-to-GDP ratio is associated with a 0.38-point decline in the international institutional rating for countries with low domestic shares, but only a 0.13-point decline for countries with a medium share — one third the impact.

The IMF conclusion:

Countries maintaining a larger share of domestic debt are more likely to command investor confidence and hence sustain higher levels of debt going forward.

(That finding may not hold, however, the authors warn, if debt levels explode and trigger expectations of high inflation, prompting investors to restructure their portfolios.)

What lessons are there for the United States?

Once upon a time, Americans owned the vast majority of U.S. Treasury securities. But in the 2000s — a time when U.S. household saving rates were extremely low — the share of foreign ownership climbed dramatically, as seen in this chart:

Sources: TreasuryDirect and “Major Foreign Holders of Treasury Securities.”

It is not clear whether the U.S. falls into the IMF's “low” or “medium” foreign indebtedness category, but the direction during the decade was consistently one way: up. By the end of the decade, foreigners accounted for roughly half of all new debt and until the Fed started borrowing heavily it looked like the trend would hold indefinitely.

Foreign investors have every reason to be leery about getting too deeply committed to U.S. debt. As I have observed on numerous occasions, foreign investors do not vote, and they are not allowed to contribute to election campaigns. They have zero direct influence in the American political process. Their only influence is indirect: the ability to exercise a vote of no confidence by selling their holdings… or refusing to invest any more. The Chinese,who have stopped acuumulating U.S. Treasury debt, appear to have reached that point already.

And who could blame them? If the U.S. faces a debt crisis, as I believe it will, it will have limited options. It can cut spending or raise taxes to reduce deficits, which would only deepen the country’s economic agonies. The Fed can borrow the money with fiat money, running the risk of massive inflation, which would erode the value of all investments, both domestic and foreign. Or, it can go the Argentina route, and stick it to foreign creditors. Of course, that strategy would have drawbacks, as well. The value of the dollar would plummet and foreign lending would dry up.

If foreigners follow the same line of thinking, however, at some point they will be relucant to increase their ownership share of U.S. debt beyond ther current 30% share -- unless their investments are sweetened with higher yields on U.S. securities.

That’s assuming that all other things are equal, which, of course, they are not. Right now, turmoil in the euro bond markets outweighs more theoretical concerns about U.S. indebtedness, and the Treasury is the beneficiary of flight-to-safety capital. But sooner or later, the Europeans will work out their sovereign indebtedness issues — possibly culminating with the break-up of the euro — which could lead to the repatriation of capital back to European nations with stronger currencies. In that case, investor attention will refocus on the risks associated with U.S. debt.

Whatever the case, it is in the interest of the U.S. Treasury to attract domestic investment, and that is unlikely to happen unless Americans increase their households saving rates. After hitting rock bottom in the mid-2000s, saving has climbed back to the 4% to 6% range, but that’s not nearly enough to fund U.S. deficits going forward. From this perspective, economic policy makers would be well advised to implement tax and monetary policies that encourage domestic saving.

Source: The Perils of Foreign Debt