Considerations In the Management of Sovereign Debt Dilemmas

TaxConnections Blog PostINTRODUCTION

With all the attention that is focused upon the inability of the United States government to facilitate harmony and solution in the legislative and executive branches regarding national debt, it might be a moment to reflect upon just where the implications of debt default arise. In a more indirect way, those implications do have a bearing upon taxation and governmental policy. They present real issues for accountant’s managing international business structures. (For reference see Currency and International Financial Centers, 30/September 2013, TaxConnections, International, Tax Blogoshere, United States.)

Government policy impacts and has transmission effects that ripple across foreign investment considerations regarding direct investment in the United States from offshore. That impacts integration of the global market place. As will be touched upon, the international financial system is integrated to the extent that a decision by a sovereign as to its monetary policy, alone, impacts its base currency, its eurodollar currency, and all the cross currency relationships across the globe. The uncertainty created by loggerhead dramatics does not promote global stability requisite to sound financial taxation planning.

EFFECTS OF FOREIGN SOVEREIGN IMMUNITY AND ACT OF STATE DOCTRINE

In connection with considerations given to these financial effects, it is appropriate to engage the concepts referred to as Sovereign Immunity and the Act of State Doctrine. These concepts are enforcement barriers in litigation. Equally important, the Act of State Doctrine impacts one of the vital considerations of sovereigns and policy. To adequately explain the Act of State Doctrine, it is helpful to contrast it with the doctrine of Foreign Sovereign Immunity.

Sovereign Immunity as it has evolved to this date enables a sovereign to plead as a jurisdictional defense to a claim that it is immune from jurisdiction of foreign courts. The theory was that the executive arms of the governmental body possessed the authority and mandate to deal with foreign affairs and it was not appropriate for courts to intervene when it involved the balancing of foreign relations and private interests. There are comity considerations. The Sovereign Immunity Doctrine is a jurisdictional defense and a doctrine utilized by governments. It can only be asserted by the governmental body. There is no jurisdiction if there is Sovereign Immunity.

The Act of State Doctrine is distinguished from Sovereign Immunity because it is conceptually rooted in the competency of the court to hear a matter. This doctrine operates so as to confer a presumption of validity regarding certain acts of foreign sovereigns by rendering non-justiciable claims that challenge such acts. This judicially created doctrine is not truly jurisdictional; it is, rather, a rule of decision pursuant to which an act meeting the definition is binding on the court. It does not deal with the authority of the courts. Instead, it runs to the questions of its competence.

The Act of State doctrine is designed to avoid judicial action that would impinge on the foreign relations of the United States. This doctrine ultimately derives from the separation of powers that is provided in the Constitution. Comity is its substance and is founded on forbearance and mutual sovereign respect. The defense is prudential and substantive and not jurisdictional.

The particular significance of this doctrine with respect to International Financial Centers is etched in sovereign ability to confiscate or expropriate property within its territory and the imposition of currency controls. The Act of State Doctrine, unlike the doctrine of Sovereign Immunity, can be asserted by both an individual and the sovereign. In the expropriation context, the Act of State doctrine facilitates the ability of a sovereign to nationalize a private enterprise by the use of an Act of State Doctrine under the guise of property territorial notions.

The United States will recognize and give validity to sovereign acts by a nation when expropriating property within its territory. The reasoning is that a sovereign is entitled to make such acts within its territory and to not validate its actions would be viewed as a breach of foreign relations. A court pursuant to the Act of State Doctrine will not examine the validity of the taking of property within its own territory by a foreign sovereign recognized by the United States in the absence of a treaty or other agreement. This is the case even though the expropriation may be discriminatory, not for a public purpose, and not accompanied by prompt and reasonable compensation. This doctrine is applied in the face of the violation of United States public policy.

INTERNAL-DOMESTIC MARKET AND EXTERNAL-EUROCURRENCY MARKET

It is implicit in a sovereign’s public policy that the ramifications extend beyond its borders by virtue of many facets, but most significantly by virtue of its currency. Its affects are most pronounced through international capital flight and trade. Understanding how its taxation and public policy impact those relationships provides important insight to tax and financial planning.

Currencies involve international banking. It is a basic three-step process establishing the link between internal financial markets to external markets to explain the role that they play in the concept of currencies and the international monetary system. There are two basic financial markets, the internal market commonly referred to as the internal-domestic market and the external market commonly referred to as the external-eurocurrency market. Those two financial markets are linked together and comprise an integral working of currencies and the international monetary system. The interaction of linkage between the internal-domestic market and the external-eurocurrency market is the third element in the process.

Internal-domestic, external-eurocurrency, and foreign are terms of art in the international financial system. Importantly in defining these terms, external-eurocurrency markets are financial markets in which financial transactions are denominated in currencies other than in the currencies in which transactions take place. Such financial activities as defined as external-eurocurrency market activities, embrace by way of example, deposits, borrowing, and issuance of bonds.

External-eurocurrency markets are to be differentiated from a characterization of an international market. An international market is one in a foreign sector for an internal domestic market in which the financial transactions are denominated in the currency of the country in which the transaction is exacted. These international markets are a sector that the financial transaction takes place in residence and non-residence. External-eurocurrency financial markets contrast to internal-domestic markets with respect to their regulation and interest rate determination. These are markets that are basically outside of the internal domestic financial centers. The term external-eurocurrency markets’ is synonymous with euro-financial, euro reflecting the geographical location of the markets origin.

The external-eurocurrency market is integrated to the internal-domestic financial markets by the international transaction of global foreign exchange. The important point is to expand upon the mechanism which functions to integrate the two currency markets in the international market place and explore the influences that are exerted from the internal-domestic markets to influence the Eurocurrencies in general.

To connect the relevance of external markets to internal-domestic financial markets, it is important to differentiate them from the internal-domestic markets. It requires exploring the mechanism by which internal-domestic markets and external-eurocurrency markets have by their very existence, inter-dependence. This inter-dependence facilitates a need to understand the effects of deregulation in the external market, the effects of internal-domestic monetary policy, internal-domestic public policy, and internal-domestic fiscal policy transmissions to the external-eurocurrency markets. The interaction that results between these two financial markets casts enormous influences on the international monetary system.

To connect the relevance of external markets to internal-domestic financial markets, it is important to differentiate them from the internal-domestic markets. It requires exploring the mechanism by which internal-domestic markets and external-eurocurrency markets have by their very existence, inter-dependence. This inter-dependence facilitates a need to understand the effects of deregulation in the external market, the effects of internal-domestic monetary policy, internal-domestic public policy, and internal-domestic fiscal policy transmissions to the external-eurocurrency markets. The interaction that results between these two financial markets casts enormous influences on the international monetary system.

The term market as applied to internal-domestic, foreign, and external-eurocurrency markets should be distinguished; these markets are delineated pursuant to which payments are made and credit is extended. Currency is of national origin, being produced by a particular government. Because currency is of national origin, the exchange of currencies is necessary to make payments in another currency. The underlying concept of the market for foreign exchange is derived because it is based upon the market in which different national means of payments are traded.

However, there is an absolute link between external-eurocurrency markets and internal-domestic markets. It manifests itself in interest rate relationships, risk tolerance, and public policy. The euro-currency markets are closely linked to the respective domestic-internal market through international transactions. The act of an internal-domestic economy’s central bank such as the Federal Reserve has profound transmission effects to the external-eurocurrency market. An emphatic effect is transmitted to the external-eurocurrency market of a currency at such time as an increase in a federal fund rate is applied. It has been observed with the most recent off-again, on-again effect of so-called tapering of Q-E. One may want to reflect on that and then align it with the transmission effect of a public policy that seems nonchalant to a default of the world’s most homogenous currency, supporting government obligations. The market place maybe resilient, but not foolish.

The effect of interest rate relationships is promoted through deeply developed external-eurocurrency markets. It serves to integrate markets in terms of interest rates. Interest rates translate into price and that tends to impact developments in the internal-domestic markets. This linkage of interest rates of the internal-domestic market and the external-eurocurrency market directly influences currency values. It is perhaps the most influential monetary aspect that governs currency values from day to day.

Internal-domestic monetary policy is a factor that affects these relationships in the internal-domestic markets and external-eurocurrency markets. A central bank of a major economy, such as the Federal Reserve in the United States, can directly affect these interest rate relationships. If the federal funds rate in the United States is raised as an action of monetary policy, an open market action, United States dollar investors in the external-eurocurrency market will move funds to the United States because the flow will settle where the higher rate is available in conjunction with risk assumptions.

As a natural occurrence, the lending rate in the external-eurocurrency market of the United States dollar will decline. External-eurocurrency market deposit rates will rise to reflect a lower demand for eurocurrency United States dollar deposits and an increase in demand for external-eurocurrency United States dollar loans.

In summary, it is a theoretical conclusion that the process that concludes those differences between inflation rates of two currencies are equal to the rate of change of the exchange rate. The expectation that exchange rates will depreciate or appreciate pressures the forward currency contract rate, pressures the interest rates, and those pressures are reflected in the forward or spot currency exchange contract markets. It is a simultaneous efficiency between internal-domestic markets and external-eurocurrency markets that affects exchange rates and interest rates. The management of risk is greatly focused on these two aspects, exchange rates and interest rates. Derivative financial innovative instruments seek to accomplish the management of these risks and needs to be a priority of thoughtful planning.

In accordance with Circular 230 Disclosure

William Richards is a Sole Practitioner in Orlando, Florida, USA 32626. Attorney at Law, Legal Advisor. 1978 – Present

PUBLICATIONS: International Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2012, 378 pages. The Handbook of Offshore Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2004, 266 pages; Offshore Financial Centers and Tax Havens, Archives of Tulane Law Library, Tulane Law School, Tulane University, New Orleans, Louisiana, Copyright, 1996, 512 Pages.

Subscribe to TaxConnections Blog

Enter your email address to subscribe to this blog and receive notifications of new posts by email.