Sovereign Bond Returns (1815 – 2016)*
Chart is Recreated Using Data from Table 3 in: Josefin Meyer, Carmen M. Reinhart, Christoph Trebesch. “Sovereign Bonds Since Waterloo” (2019)
*”average ex-post investor returns in our total sample of 91 countries and 200 years, as well as for different subsamples. The country composition is changing over time… Returns and standard deviations shown are based on a global portfolio that includes all outstanding foreign-currency sovereign bonds at each point in time.”
From the Archives
The Economist (August 1, 1914)
The first issue of The Economist following the outbreak of WWI. Eerie reading…
“The condition of the foreign exchanges is, we believe, without precedent, and the world seems to be returning to a basis of cash and barter. The closing of the Stock Exchange yesterday caused quite a run for gold upon the Lonodn banks, and unless a proclamation of neutrality relieves the strain worse may ensue. The City has seen in a flash the meaning of war.”
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“Uncle Sam – Here is a ship more powerful than my strongest ship of war. You can’t resist it!”
The content of last week’s Sunday Reads focused on how markets reacted to the outbreak of war and invasions. This week, we are going to focus more on the weaponization of finance/economics, and how countries can inflict economic “sieges” against their enemies. If you missed last week, make sure to read! (A History of Invasions, Wars & Markets)
Many historians point to the Battle of Megiddo in 15th century B.C. Palestine as the first major siege in history. The Egyptian Pharaoh Thutmose III surrounded the city of Megiddo for seven long months, cutting off its citizens access to food and supplies. Without access to these necessities, the starving Megiddo enemies eventually surrendered. Siege warfare became more ubiquitous over the ensuing millennia as military leaders recognized the efficacy of this tactic.
Russia is no stranger to sieges. During World War II, Leningrad – now St. Petersburg – endured an 872 day siege at the hands of Nazi soldiers, lasting from September 8, 1941 – January 27, 1944. The Nazi army wrested control of the railway lines and roads entering Leningrad, shutting off its access to the outside world (apart from one lake). Effectively cut off from food supplies, the winter of 1941/1942 brought a “starvation epidemic that claimed as many as 100,000 lives per month.” In total, estimates suggest that roughly 800,000 people died during this lengthy siege.
If this Leningrad Siege sounds familiar… a 77-year-old Russian woman that survived that siege was arrested in St. Petersburg (formerly Leningrad) this week for protesting Putin’s invasion.
Russia & Economic Sieges
You may be thinking “why is Jamie talking this much about sieges?” Fair.
Well, the myriad of sanctions imposed on Russia can be thought of like an economic siege similarly designed to cut off Russia’s access to monetary “supplies” and financing. In the past, armies surrounded fortified cities to block their access to food and necessities. Today, global leaders can turn off Russia’s access to important networks and funding sources. In either era, the most damaging sieges are inflicted when the victims have little-to-no idea that they are imminent, which means that they do not build up a stockpile of food and supplies in advance. The siege will be bad either way, but the opportunity to accumulate supplies beforehand helps matters.
The Siege of Leningrad was particularly brutal because the Nazi’s decision to lay siege came as a surprise to Russian leaders and “officials had been dangerously negligent in stockpiling food” (History). Flashing forward to the modern era, the sanctions (economic siege) imposed on Russia following it’s annexation of Crimea in 2014 were similarly damaging from an economic perspective:
“Western nations responded with sanctions aimed at making it more difficult for Russia to transact in the U.S.-dominated global financial system. The repercussions from that episode were severe. Combined with a collapse in oil prices that year, it sent the ruble tumbling more than 40% against the U.S. dollar, forcing the Russian central bank to enact dramatic interest-rate increases that pushed the economy into recession.” (Bloomberg)
To protect Russia’s economy from being similarly damaged from future rounds of sanctions, Putin and the Russian Central Bank began strategically accumulating a large amount of foreign exchange reserves. These “foreign exchange reserves” are assets in foreign currencies held by central banks (i.e. China’s central bank owning US Treasury Bonds), and can help central banks support their domestic currency / economy by buying or selling these foreign currency reserves.
So, Russia has spent the last eight years accumulating a $630 billion war-chest of foreign reserve assets to make sure that it was better prepared for the West’s next economic siege (sanctions). As The Economist put it: “the aim of Russia’s macroeconomic policy has been not to foster growth but rather to build a fortress economy that could withstand a severe shock.” Speaking to the buildup of foreign reserves, a former Russian Central Bank official explained last year: “We’re protected against external shocks and foreign enemies because we have modern weapons and rockets, but also because we have gold and reserves” (Economist).
Importantly, Russia’s Central Bank also changed the breakdown of its foreign reserve assets, moving out of countries like the United States and into countries like China. The Bloomberg chart below portrays Russia’s foreign reserves breakdown in December 2013 (before the Crimea Annexation) and June 2021.
Yet, Putin did not anticipate Western nations taking the drastic decision to cut off Russia’s access to these foreign reserves. On February 26th, the United States, Europe and Canada announced that the Bank of Russia would be barred from accessing its foreign reserves held in each respective entities currency. So, just like that, Putin’s foreign reserve assets meant to support the Ruble and Russian economy during this crisis were effectively cut in half overnight.
This is equivalent to Leningrad citizens spending eight long years stockpiling food and supplies in preparation for the next Nazi siege, but then discovering half of their food supplies were rotten when Nazi soldiers returned.
Conflict & Defaults
One knock-on effect of situations like that in Ukraine and Russia is defaulting on government debt. If Country A is at war / has open hostilities with Country B, it is unlikely that either side will wish to pay out interest payments on its government debt to the other side (assuming they own the government’s debt). That said… The Wall Street Journal reported this week that the “holders of a ruble-denominated government bond maturing in 2024 are meant to receive payment on Thursday for a coupon due the previous day. Investors in Europe that own this bond say they haven’t received it or any notifications that it is on its way.” Russia also has a roughly $115 million interest payment due to investors holding dollar-denominated debt on March 16th.
How can one country force a debtor country to make good on its payments? Well, if you are British Prime Minister Palmerston in the 19th century and the Egyptians are not being timely with their payments, you threaten to send the Royal Navy after them…
“The patience and forbearance of His Majesty’s government…have reached their limit, and if the sums due to the British…claimants are not paid… His Majesty’s Admiral commanding on the West India Station will receive orders to take such measures as may be necessary to obtain justice.”
Are there historical examples of this type of intentional default on payments for political reasons? Of course! In fact, one particularly interesting example involves Russia. The always brilliant Tracy Alloway detailed this case study for my latest online financial history course on empires, conflicts and markets (enter SUBSCRIBER20 for 20% off). Watch this preview below:
Geopolitics & Economic Warfare
The last few weeks have clearly demonstrated that financial instruments and economic tools can be weaponized to inflict pain on enemies like Russia. In another lecture from my course, John Handel reveals how the geopolitics of debt between European powers on the eve of World War I helped fuel the outbreak of war. As John points out, countries like France and Germany would often wield their economic prowess as a tool for dominating small nations like Bulgaria and Serbia.
This dominance might come in the form of requiring countries seeking funds from France/Germany to purchase large amounts of military supplies from the creditor nation. John explains more:
With that, let’s get into today’s Sunday Reads covering sanctions, conflict, markets and war.
Super-Sanctions and Sovereign Debt Repayment
Why This is Relevant:
There has been much discussion around Russia’s intent (or ability) to make good on interest payments for existing government bonds. The Wall Street Journal reported this week that the “holders of a ruble-denominated government bond maturing in 2024 are meant to receive payment on Thursday for a coupon due the previous day. Investors in Europe that own this bond say they haven’t received it or any notifications that it is on its way.” Russia has a roughly $115 Million interest payment due to investors holding dollar-denominated debt on March 16th. Time will tell if they default on this payment or not.
“This paper examines the role of sanctions in promoting debt repayment during the classical gold standard period. We analyze a wide range of sanctions including gunboat diplomacy, external fiscal control over a country’s finances, asset seizures by private creditors, and trade sanctions. We find that “supersanctions”, instances where military pressure or political control were applied in response to default, were an important and commonly used enforcement mechanism from 1870-1913. Following the implementation of supersanctions, on average, ex ante default probabilities on new debt issues fell by more than 60 percent, yield spreads declined approximately 800 basis points, and defaulting countries experienced almost a 100 percent reduction of time spent in default. We also find that debt defaulters that surrendered their fiscal sovereignty for an extended period of time were able to issue large amounts of new debt on international capital markets. Consistent with policies advocated by Caballero and Dornbusch (2002) for Argentina, our results suggest that third-party enforcement mechanisms, with the authority to enact financial and fiscal reforms, may be beneficial for resuscitating the capital market reputation of sovereign defaulters.
“The enforcement mechanism that seems to have been more important, at least from a sanctions perspective, was the imposition of foreign financial control or gunboat diplomacy…
we find that supersanctions were an effective enforcement mechanism that was employed nearly 30 percent of the time after a sovereign debt default, and on more than 40 percent of all defaulted debt from the gold standard period. The use of gunboats or financial “house arrest” had a significant impact on the reputation of sovereign debtors in the London capital market and appears to have deterred future default.
According to data on new debt issues, the ex ante default probability on a principal default decreased by more than 60 percent after a country had been supersanctioned. We also find that a country’s risk premium, measured as the yield spread over consols, declined by approximately 800 basis points after the implementation of supersanctions.”
Markets Under Siege
Why This is Relevant:
A look at how French bond (rente) prices reacted to the Siege of Paris by Prussian troops from 1870-1871.
“Can differences in beliefs about politics, particularly the benefits of war and peace, move markets? During the Siege of Paris by the Prussian army (1870-71) and its aftermath, we document that the price of the French 3% sovereign bond (rente) differed persistently between the Bourse in Paris and elsewhere, despite being one of the most widely held and actively traded financial assets in continental Europe. Further, these differences were large, reaching the equivalent of almost 1% of French GDP in overall value. We show these differences manifested themselves during the period of limited arbitrage induced by the Siege and persisted until the terms of peace were revealed.
As long as French military resistance continued, the rente price was higher in Paris than the outside markets, but when the parties ceased fire and started negotiating peace terms this pattern was reversed. Further, while the price responded more to war events in Paris, the price responded more to peace events elsewhere.
These specific patterns are difficult to reconcile with other potential mechanisms, including differential information sets, need for liquidity, or relative market thickness. Instead, we argue, these results are consistent with prices reflecting the updating of different prevailing political beliefs that existed in Paris and elsewhere about the benefits of war and peace.”
“In 1870, French financial markets, along with Paris itself, came under siege. The besieging Prussian army cut the telegraph lines out of the City, leaving communications to be largely entrusted to carrier pigeons and hot air balloons.1 Despite the Siege, both the main Bourse in beleaguered Paris and other French stock exchanges still connected to the rest of the world—particularly in Bordeaux and Lyon—continued to function.”
Jubilee Jim Fisk & The Great Civil War Score
Why This is Relevant:
This is a wildly entertaining story about one bold speculator executing the original “big short” in Civil War America.
“Fisk had wooed clients with booze to persuade them to let him invest their money in stocks and bonds. But before he knew it, Fisk was caught in a bear market. As he pumped money into the black hole of speculations, his losses mounted. He was one of the many casualties of Civil War Wall Street, with outcomes on battlefields as far away as Mississippi sending the stock market and gold prices on wild, unpredictable swings. Fisk was busted, but he vowed to be back. “Wall Street has ruined me,” he proclaimed, “and Wall Street shall pay for it”…
Opening a New York City newspaper, he scanned to the financial news coming in from London… Fisk couldn’t help but notice listings in London for Confederate bonds. Where some patriotic Northerners saw a source of derision, Fisk saw opportunity: He wanted to short the bonds of the Confederate States of America.”
“The idea of exploiting privileged information for financial gain using technology was something that would have crossed Fisk’s transom earlier in the Civil War. Western Union employees, for example, had allegedly made a fortune in the gold markets by leveraging their advance knowledge of war news in the first months of the conflict.
Confederate war bonds had been trading in London since 1863, at times nearly at par, or face value. By the early months of 1865, the bonds could be purchased for some 35 cents on the dollar. Fisk knew that once the Confederacy was toppled and word spread, the price of the bonds would plummet even further — probably to mere cents on the dollar. An investor in the right positions if that happened could earn a fortune.”
Banks & The WWI Agricultural Price Shock
Why This is Relevant:
Wheat prices are soaring today, but what happened to crop prices during and after World War I? This paper dives into the boom and bust cycle of agriculture prices following the end of “The Great War”.
“This paper studies the interplay of bank lending and asset prices in the boom-bust cycle affecting U.S. agricultural land prices during and after World War I… the farmland boom of the 1910s had a clearly identifiable trigger.
The wartime collapse of European agriculture drove commodity prices sharply higher and constituted an external demand shock that sparked the boom in U.S. farmland prices. However, the boom was short-lived. European production bounced back quickly when the war ended, driving down crop prices and land values in the United States, and initiating a wave of farm foreclosures and bank failures in the early 1920s.
“The World War I agricultural boom and post-war bust is a particularly useful episode for studying the interrelationship between banks and asset prices. Triggered by the collapse of European agriculture during the war, rapidly rising commodity prices ignited a farmland price boom in the United States. Rajan and Ramcharan (2015a) show that the availability of credit contributed to the boom in land values and mortgage debt at the county-level. Here, using bank-level data, we show how the banking system became enmeshed in the boom. While older banks increased their lending to accommodate rising credit demand, new banks were established and expanded even more aggressively. Similar to the “shadow” banks of the modern era, state-chartered banks responded more strongly to the asset boom than did more tightly regulated national banks.”
Disciplining the ‘Black Sheep of the Balkans’: Financial Supervision and Sovereignty in Bulgaria
Why This is Relevant:
Best explained by John Handel’s video at the beginning of today’s post.
“Using the example of Bulgaria, we argue that familiar models of international political economy fail to capture the tension between national sovereignty and access to capital markets experienced by peripheral debtors in the late nineteenth and early twentieth centuries. Existing accounts exaggerate the significance of the gold standard as a good housekeeping seal of approval and underestimate the role of direct financial controls. Furthermore, they underestimate the linkage in zones of inter imperial rivalry, such as the Balkans, between foreign borrowing and strategic alignment.
We show how Bulgaria found its politics destabilized prior to 1914 by the demands of its creditors. After defeat in the First World War, Bulgaria was forced to submit to an even tighter system of creditor control. Though it obtained substantial debt relief during the 1930s, these concessions were gained not through an assertion of national sovereignty and default, but at the price of even closer supervision. This in turn casts new light on the conventional view of Bulgaria as a victim of Nazi ‘informal imperialism’. In light of Bulgaria’s previous experience, the more striking feature of its trade relations with Hitler’s Germany is that they were conducted on a basis of sovereign equality.
“From the 1890s onwards the receipt of funding was tied quite explicitly to adherence to one or other of the military blocs that were increasingly destabilizing European politics. In some cases, where creditors’ and debtors’ strategic interests were aligned, one might speak as scholars of the twentieth-century Marshall Plan have done, of a form of ’empire by invitation’.”
The Global Crisis of Commodity Glut During the Second World War
Why This is Relevant:
The Russia-Ukraine crisis has led to booming commodity prices (FT graph below). This article looks at how commodity prices behaved during another important conflict: World War II. As the author – Jamie Martin – shows, the swings in commodity prices had important geopolitical consequences.
“This article examines the global crisis of commodity glut that came in the wake of the Fall of France and Italy’s entry into the Second World War in June 1940, when the extension of the British blockade and shipping problems cut off primary producers around the world from major continental European markets. As a surplus of unmarketable primary commodities piled up in British colonies, as well as in Latin America and French, Dutch, and Belgian colonies, this jeopardized the blockade and threatened political unrest across the British Empire, as well as the spread of Nazi influence in Latin America. This article examines how the British government attempted to respond to this crisis, both unilaterally and in combination with the U.S. government. In doing so, it argues that Anglo-American negotiations over a joint approach to the problem of commodity glut led to some of the earliest attempts to create new international economic organizations for the postwar period. While these plans were transformed as the surplus problem itself changed in late 1941, they nonetheless laid the groundwork for Anglo-American relief planning, contentious negotiations over an international wheat agreement, and international commodity price stabilization schemes.”
“a Pandora’s box was opened. Over the summer and autumn of 1941, the U.S. government pushed for an international wheat agreement that demanded cutting subsidies to domestic British producers and reducing acreage devoted to wheat cultivation – a demand that in the best of times would have been controversial, but that now was seen as a direct affront to the British war economy.
The proposed wheat agreement called for the price of wheat to be fixed by a new international organization dominated by representatives of the four largest producers, who were almost certain to fix its price to the detriment of British importers, just as Britain’s balance of payments situation worsened. To top it off, the proposal called for the British to help ‘police’ the arrangement by refusing to purchase wheat from any country that did not join it, which meant an end to any semblance of free trade in the staple crop and the extension of government controls after the war. This was seen by many in London as a humiliating demand to enforce rules detrimental to the British economy for the sake of appeasing the Americans.”
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