Sovereign default

Definition

The term sovereign default is generally taken to refer to the failure of a government to comply with its interest payment or debt repayment obligations in respect of its bonds or bank loans. That is not a working definition, however, because it is necessary for practical purposes to ignore trivial defaults such as briefly delayed payments, and to make a choice among a range of options such as whether to include the agreed restructuring or rescheduling of debt, or international bail-outs of sovereign debtors - and whether the term is to include domestic as well as foreign creditors, and debts to foreign governments as well as foreign private sector creditors. There is no generally accepted practice concerning those choices.

Overview

Governments have from time to time chosen to stop servicing their debts rather than attempt to raise the necessary money by taxation. In most cases that choice was effectively forced upon the government concerned by a combination of economic and currency crises, and in most cases it was followed by a restructuring agreement between the defaulting government and its creditors, and the resumption of payments. Under the terms of the post-war Bretton Woods agreement, intervention by the International Monetary Fund may be called upon in order to avoid or mitigate the damage done by sovereign default. Since the 1990s, the ability to insure against default by the purchase of credit default swaps has affected the incidence of default and added to the influence of the credit rating agencies.

Post-war sovereign defaults have been confined to emerging market economies, but the increases in national debt brought about by the recession of 2009 have raised the possibility of default by countries with an established market economies, as indicated by a growth in the risk premiums that have been added to their bond yields.

History

The isolated sovereign defaults that occurred before the 19th century arose mainly from domestic politics or wartime refusal to make payments to enemy creditors. The more numerous defaults of the 19th century were influenced more by international commerce, were concentrated in a few recurring episodes, and tended to infect trading partners. Those of the early twentieth century were mainly associated with the First World War or with the great depression and the operation of the gold standard. Defaults were rare in the post-war years before a concentrated episode that occurred in the early 1980s and another around the turn of the century - both of them associated with the development of deregulation and globalisation.

The development of international financial mobility in the 19th century led to three groups of default episodes, clustered around the 1830s, the 1860s and the 1890s, and mainly associated with the collapse of booms in lending to emerging economies from Britain and France . They were concentrated in Latin America apart from a handful in the then peripheral European countries of Greece, Spain and Portugal. The Latin American defaults of the 1890s were triggered by doubts about Argentina’s economic stability, which led to the collapse of London's Baring Brothers bank, that had underwritten an Argentine bond, and was followed by the abrupt withdrawal of all lending to Latin America and defaults by six other South American countries .

During the inter-war period there were 39 default episodes more than half of which occurred in Latin American countries and 16 of them in Europe . In the course of the Great Depression of the 1930s most European governments defaulted on their debts, following unsuccessful attempts to remain on the gold standard. In 1932, the British Government effectively defaulted by converting its 5% War Loan Bonds into new 3½ % bonds on terms that were unfavourable to their holders, and in 1934 the French government defaulted on repayment of a loan from the United States.

There were relatively few post-war defaults until the 1980s but there were over 110 default and debt restructuring episodes between 1980 and 2004, most of them involving African and South American governments . Most of them were combined with banking or currency crises, and some of them with both. The worst and most far-reaching instances were Russia's 1998 default and Argentina's 2001 default, both of which were associated with failed exchange rate policies. Increases in international capital mobility had by then made some Asian countries vulnerable to sudden reversals in capital flows, and the resulting Asian banking crisis, and although there were few actual defaults, the severity of those crises raised investors' awareness of the dangers of default.

There have been no post-war defaults by the governments of western Europe, but increases in their public debt in the course of the Great Recession have prompted bond market operators to increase the risk premiums on bond issues by the PIIGS members of the European Monetary Union following rating downgrades by the credit rating agencies.

Causes of default

Sovereign default is always the outcome of a government decision that default is preferable to the increase in the tax burden (or the reduction in expenditure) that would be necessary in order to meet its debt obligations. Such debt obligations are always the result of growth in the level of the national debt, and in the absence of external shocks, the fiscal policy action needed to avoid such excessive growth is determined by the debt trap identity (which relates the budget surplus needed to reduce the national debt to the level of that debt, the interest rate payable and the growth rate of national income). Many defaults have, however, been triggered by externally generated economic shocks, and have involved countries with levels of debt that would not otherwise have occasioned financing difficulties. Defaults by the governments of the emerging market economies have often followed a sudden reversal of international capital flows, and the major defaults by the governments of Russia and Argentina were partly attributable to the difficulty of defending a fixed exchange rate against speculative attack.

However, the level of national debt is far from being the sole determinant of default and some established market economies have weathered national debt burdens in excess of 250 percent of GDP without default, whereas the governments of developing countries with a history of serial defaults are liable to default again if their national debt exceeds a limit as low as 15 per cent of GDP. Countries with a record of macroeconomic instability have been shown to be especially prone to default, and other factors that have been found to make developing countries prone to default are low levels of economic growth, inflationary tendencies and political uncertainties. Their vulnerability is usually increased by the fact that - unlike the developed countries - they are usually unable to raise money by selling bonds denominated in their own currency (a problem that is sometimes referred to as original sin, and as a result, a falling exchange raises the domestic cost of repayment by creating a currency mismatch.

The costs of default

Estimation of the costs of sovereign defaults has been hampered by the difficulty of distinguishing the consequences of a default from the other consequences of the events that caused it. A study by Bank of England economists identified substantial cost penalties, but only for defaults that had been accompanied by exchange rate or banking crises but a study by IMF economists concluded that sovereign defaults tended to cause banking crises rather than being caused by them. The same IMF economists' study indicated that defaults damage reputations, especially of the politicians deemed to be responsible. Other studies have shown past defaults to be one of the reasons for debt aversion on the part of the bond market, and another IMF study suggested that even the risk of default had hampered private sector access to capital

The influence of the bond market

The international bond market increases the yield that it expects from a country's bonds if it rates that country's risk of default as significant - thus raising the cost to that country of servicing its debt by the addition of a "risk premium". That tendency to react to a default risk in such a way as to increase it, is a form of positive feedback which can, in extreme cases, generate a destructive cycle of ever-increasing risk premiums, ending in default. Fear of such an outcome is, in turn a factor that affects the conduct of the market toward particular countries. The reaction of the market to countries judged to be more prone to default than others that have the same debt burden has been termed debt intolerance.

The rapid expansion during the early 21st century of a form of risk insurance termed the credit default swap (CDS) has led to the creation of an unregulated market in default risk. Traders in that market include speculators in the prices of "naked CDSs" as well as holders of the related bonds. The annual percentage cost of a CDS for a country's bond is termed the CDS spread for that bond, which is a measure of the credit risk of holding that bond, and is normally reflected in the risk premium component of its yield. A related measure of the risk of holding a country's bond is its sovereign spread, which is the difference between its yield and that of a comparable bond issued by a low-risk benchmark country.

The bond market is influenced by the credit risk assessments of the major credit rating agencies who base their sovereign credit ratings on a range of credit rating criteria that include various aspects of financial and economic performance as well as relative levels of debt burden. Implied default probabilities range from zero for the highest AAA ratings through about 0.5 percent for the highest B rating to upwards of 1.2 percent for the C grades.

Before the Great Recession, the incidence of debt intolerance was confined to the bond issues of the developing economies, but it has been suggested that it has since been applied to Greece and, possibly to other members of the European Union, including Ireland.

The role of the credit rating agencies

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