This is a superb paper which looks at bond markets in colonies and sovereigns:
In a recent paper, we study the pricing of government debt in a setup that provides both insightful institutional parallels, and an empirically much friendlier environment (Chavaz and Flandreau 2015). During what some economists call the ‘first globalisation’ era (1870-1914), 68 countries raised funds in sterling on the London Stock Exchange (LSE). With good reason: London was home to the most astute sovereign underwriters, and an ample supply of capital. Countries on the gold standard would not have to worry about exchange rate risk when they borrowed in sterling. The London market had many liquid instruments. Among them, the British government’s quasi-perpetual ‘Consol’ reigned over the largest and most liquid secondary bond market worldwide.
One unique feature of the London government bond market of the time was that it was split roughly equally between truly sovereign countries – like Argentina or Greece – and colonies of the British Empire, such as Canada or Jamaica. As with pre-crisis Eurozone members, the fiscal sovereignty of colonies at that time is best described as ambiguous. By law, colonies ran their own budget with either a quasi-full autonomy (in the case of self-governing dominions such as Canada and the Australian colonies), or a limited one (for Crown Colonies such as Jamaica). In reality there was a widely-held perception that London would prevent default, maybe by doing ‘whatever it takes’. Bond prospectuses never explicitly stated this as policy but, as British parliamentarian (and future prime minister) Benjamin Disraeli emphasised after the 1857 Sepoy mutiny in India, it would be very difficult not to bail out, in some way, a colony that threatened to default.
The consequence at the time it was that credit risk was hardly priced for colonies. This was later confirmed by econometricians (Accominotti et al. 2011). Despite this, colonial spreads over the British Consol averaged about 1%, or 100 basis points. They also varied substantially across time, and between colonies.
When investigating liquidity, a convenient feature of LSE quotations is that they provided precise information on the range in which transactions were expected to take place for any given security – not a true bid-ask spread, but a kind of measure of liquidity. We discovered that this range is a solid proxy for measuring bid-ask spreads at that time.
The results just show this as well. Colonies did not face credit risk but faced illiquidity risk:
Our conclusion – backed by institutional analysis, historical evidence and econometric tests – is that colonies’ semi-sovereignty significantly decreased the severity of information asymmetries between issuers and primary market investors, and among secondary market investors. In turn, this resulted in two paradoxes of semi-sovereignty.
- Because of different information asymmetries, the two foreign debt markets (sovereigns and colonies) were characterised by different underwriting technologies. Sovereigns typically tried to buy the services of prestigious merchant banks to circumvent the pre-commitment problem inherent to sovereign borrowing (Flandreau and Flores 2009). Deep-pocketed bankers not only lent prestige at issuance, but also stood ready to promote liquidity in the secondary market. Given the absence of severe information asymmetries for investment in the colonies, this was a much less attractive business in the case of colonial debts, and merchant banks soon disappeared from colonial issuances. Instead, colonies used a variety of unusual intermediaries such as second-tier commercial banks or broker-underwriters, both with little means or interest in promoting liquidity. This is the first paradox of semi-sovereignty: it lowered credit risk, but at the price of higher illiquidity risk.
- For related reasons, the two markets had different clienteles. The absence of asymmetries of information made colonial bonds a natural habitat for those in search of securities free from adverse selection, like insurance companies, commercial banks, and uninformed rentiers who were seeking to cash in coupon payments. This is the second paradox of semi-sovereignty: the lack of adverse selection further worsened bond liquidity by attracting investors that rarely traded.
The parallels between Eurozone and colonial bonds are important. They suggest that the pricing of liquidity and credit in government bond markets may be ‘always and everywhere an institutional phenomenon’. Our historical evidence suggests that investigating the microstructures of sovereign debt markets – their logic, operation, and segmentation – might help in interpreting bond price movements. For policymakers, our research may provide an encouragement to investigate which institutional features can explain the survival of the British imperial architecture, while that of Eurozone was deemed fragile enough to allow destructive liquidity-credit feedback loops.