Sovereign default: Difference between revisions
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==Causes of default== | ==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 | 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 [[Fiscal policy/Tutorials#Debt trap identity|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, and major factors behind the current speculation about the possibility of default by the governments of Ireland and Greece were the deficit increases brought about by the international [[recession of 2009]]. | ||
However, the level of national debt is far from being the sole determinant of default and some established market economies have weathered levels of national debt in excess of 250 percent without default<ref>[http://www.ifs.org.uk/bns/bn26.pdf Tom Clark and Andrew Dilnot ''Measuring the UK Fiscal Stance since the Second World War'', Fig 3, page 5, Institute of Fiscal Studies,2002]</ref>, 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<ref>[http://www.imf.org/external/pubs/ft/wp/2003/wp03221.pdf Paolo Manasse, Nouriel Roubini, and Axel Schimmelpfennig: ''Predicting Sovereign Debt Crises'', IMF Working Paper, International Monetary Fund, November 2003]</ref>. 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 (economics)|original sin]], and as a result, a falling exchange raises the domestic cost of repayment by creating a [[currency mismatch]]. | However, the level of national debt is far from being the sole determinant of default and some established market economies have weathered levels of national debt in excess of 250 percent without default<ref>[http://www.ifs.org.uk/bns/bn26.pdf Tom Clark and Andrew Dilnot ''Measuring the UK Fiscal Stance since the Second World War'', Fig 3, page 5, Institute of Fiscal Studies,2002]</ref>, 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<ref>[http://www.imf.org/external/pubs/ft/wp/2003/wp03221.pdf Paolo Manasse, Nouriel Roubini, and Axel Schimmelpfennig: ''Predicting Sovereign Debt Crises'', IMF Working Paper, International Monetary Fund, November 2003]</ref>. 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 (economics)|original sin]], and as a result, a falling exchange raises the domestic cost of repayment by creating a [[currency mismatch]]. |
Revision as of 15:17, 7 March 2010
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. 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 distressed exchanges, the agreed 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 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[1].
The development of international financial mobility in the 19th century led to three 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 [2]. 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 [3].
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[4]. 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 over 20 post-war defaults between 1980 and 2007, fewer than half of which occurred in Latin American countries. Increases in international capital mobility had made many Asian countries vulnerable to sudden reversals in capital flows, and the resulting Asian banking crisis had raised investors awareness of the dangers of default and increased the tendency for the contagion of sovereign debt problems. 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. Risk assessments by the credit rating agencies assumed an increasingly important role.
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, and major factors behind the current speculation about the possibility of default by the governments of Ireland and Greece were the deficit increases brought about by the international recession of 2009.
However, the level of national debt is far from being the sole determinant of default and some established market economies have weathered levels of national debt in excess of 250 percent without default[5], 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[6]. 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.
A further factor affecting the maximum level of debt that is consistent with continuing fiscal sustainability is the danger of a self-fulfilling loss of investor confidence, and the consequent precipitous increase in the financing burden.
References
- ↑ See Carmen Reinhart: Eight Hundred Years of Financial Folly, summarised at VoxEu April 19 2008[1]
- ↑ Carmen Reinhart and Kenneth Rogoff: This Time its Different: A Panoramic View of Eight Centuries of Financial Crises, National Bureau of Economic Research Working Paper 13882, March 2008
- ↑ Albert Fishlow: Lessons from the Past: Capital Markets during the 19th Century and the Interwar Period, International Organization, Summer 1985
- ↑ Eduardo Borensztein and Ugo Panizza: The Costs of Sovereign Default, IMF Working Paper, October 2008
- ↑ Tom Clark and Andrew Dilnot Measuring the UK Fiscal Stance since the Second World War, Fig 3, page 5, Institute of Fiscal Studies,2002
- ↑ Paolo Manasse, Nouriel Roubini, and Axel Schimmelpfennig: Predicting Sovereign Debt Crises, IMF Working Paper, International Monetary Fund, November 2003