The "Sovereign Ceiling" Rule

In most countries and in most situations the private sector cannot borrow on better terms than the government.

There are two channels by which the credit-worthiness of the government affects the credit-worthiness of the private sector. First, governments tend to be, explicitly or implicitly, the lender of last resort to major banks and firms. While such "social insurance" may be economically costly, it is often a political fact of life. Second, a government credit crisis often leads to a general economic crisis that threatens the prosperity of private-sector borrowers. More generally, a country's government is often in fact the senior claimant on the country's wealth. Hence foreign lenders tend not to lend to any institution in a given country on better terms than they will lend to that country's government.

Example and Implications

When the Mexican government faced a balance of payments crisis in 1994, capital flows to the private sector quickly dried up. Thus a government liquidity crisis was transformed into a general economic crisis that threatened the health of the private banking sector.

Topic Mexican Economic Crisis