Sovereign Default in the Core? C.P. Chandrasekhar

The declaration by the government-owned conglomerate Dubai World that it proposes to unilaterally suspend payments due on its large debt has triggered a new fear in international financial circles: that of sovereign default. Strictly speaking, the sums owed by Dubai World were not sovereign debts, but debts incurred by the company. But because of the nature of the company’s ownership, these debts were seen as (implicitly) guaranteed by the Dubai government. Since Dubai is part of the United Arab Emirates, these debts were also seen as being implicitly guaranteed by the leading nation in the group, the oil-rich Abu Dhabi.

Given these features, the message sent out by the Dubai World declaration that it plans to suspend and reschedule its debt service obligations was that in today’s world nothing is secure. Other governments too can choose to default in order to reschedule excessive debt involving cumbersome payments requirements, buying time today and leaving it to future parties in power to deal with the consequences. This possibility flagged in by Dubai together with the changed distribution of sovereign debt globally has created a peculiar situation: it is not governments of poor developing countries with limited resources and limited possibilities of transformation through trade of local into foreign currencies that are now the principal source of danger, but more developed countries like Greece, Italy, the US and the United Kingdom.

Governments have always taken on debt: to finance wars, investments and day-to-day expenditures. Besides borrowing themselves they have also implicitly or explicitly guaranteed private debt, to facilitate borrowing by non-government entities. Put these together, and some of them had at different points in time borrowed “excessively”, in the sense that they had accumulated debt service commitments that were too heavy a burden given their willingness or ability to mobilise domestic resources to defray such expenditures. Governments of poorer countries were also victims of the so-called “original sin” or the inability to borrow abroad (or even at home) in the domestic currency. This meant that they needed to transform domestic resources into adequate amounts of foreign currency to meet debt service obligations denominated in terms of a foreign currency.

Inevitably, therefore, there were two contradictory aspects to sovereign debt, or debt owed by a national government. The first is that such debt was considered to be much safer than other forms of debt since it had the backing of a national government that could (normally) commandeer the resources needed to meet payments commitments. The other is that such debt is not all too safe, since unlike in the cases of individuals and firms, creditors most often cannot force governments to repay debt by taking them to the courts and having their assets liquidated. Rather, sovereign debts are potential candidates for compulsory rescheduling in terms of payment periods, interest rates and valuation or even candidates for full repudiation.

Repudiation or even compulsory rescheduling is not without costs. It affects the reputation of the country and government concerned, triggers a sharp reduction in the rating of its foreign debt and damages the ability of the country to access further debt. It could lead to the imposition of trade sanctions against the country by governments of countries from which its principal creditors originate. And these and other reputational effects can have political costs for the governments and parties that opt for such repudiation. It is the existence of such costs that are seen as ensuring that creditors do lend to governments.

The reality, of course, is that defaults have indeed occurred. In the past, these have been defaults by developing countries. According to one analysis (Borensztein & Panizza, 2008) relating to the period 1824-2004: “Latin America is the region with the highest number of default episodes at 126, Africa, with 63 episodes, is a distant second. The Latin American “lead” is, however, largely determined by the fact that Latin American countries gained independence and access to international financial markets early in the 19th century, while most African countries continued to be European colonies for another 100 or 150 years. Among the developing regions, Asia shows the lowest number of defaults.”

Most often defaults in developing countries occur when they have been the targets of a lending boom. One such boom preceded the debt crisis in Latin America in the early 1980s. Net resource flows from private creditors rose sharply in the 1970s, driven from the supply side by the huge inflows of deposits into the international banking system after the oil shocks of the 1970s. According to Jonathan Eaton and Raquel Fernandez (1995), for debtors classified by the World Bank as “severely indebted countries”, such flows peaked at nearly 2 per cent of their GNP in 1976. After the Mexican debt crisis of 1982, the direction of these flows was reversed, peaking at over 2 per cent in 1986. Sovereign debt for the group amounted to 30 per cent of GDP in 1986, partly because the rescheduling process involved provision of additional loans to prevent default.

The implication of that experience is that in the case of developing countries, the tendency to default is the result of them having been given and having accepted external debt that becomes difficult to pay either because they are subject to some shock or because the magnitude is just too large. Often a lot of this debt is not even sovereign debt but debt to the domestic private sector, provided in the belief that there is an implicit sovereign guarantee. Yet, repudiation is not necessarily an answer to the problem, since it could lead to reduced access to foreign exchange that is crucial to sustain domestic investment and even consumption. Developing country governments, therefore, accept onerous rescheduling terms (in recent years under IMF tutelage), which saves the creditor from having to write down those loans while condemning the debtor country to low growth and increased deprivation.

Having been the victims of such experiences over the last two decades of the last century, governments in many (though not all) developing countries have been cautious about taking on too much debt. This was a problem for finance since over the last decade the international financial system has once again been awash with liquidity. This has resulted in two tendencies: first, increased lending to the private sector in developing and developed countries; and, second, increased lending to developed country governments. The latter is the source of fear in the post-Dubai World period. According to The Economist (3 December 2009): “In 2007 average government debt in the G20’s big rich economies, at just under 80% of GDP, was double that of big emerging economies. By 2014 the ratio, at 120% of GDP, could be more than three times higher. That alone will challenge old rules of thumb about the relative riskiness of emerging-market debt. But it will not be the only change. The scale of contingent liabilities, such as government guarantees on bank debt, differs hugely between countries, with a far bigger increase in the rich economies at the heart of the crisis.”

The problem has been exacerbated by the effort made by a number of countries to save their banks by buying out their losses and stimulating the economy with additional spending. This has not just left the debt overhang problem untouched, it has aggravated it. Needless to say, the debt is now substantially government or sovereign debt. But increase in such debt is undermining the confidence that such debt is risk-free, especially when fiscal deficits, exceed 10 per cent or more of GDP as they do in Ireland, Greece and Spain.

One economy in the eurozone which is the focus of attention is Greece. With a budget deficit that is expected to touch at least 12.7 per cent of GDP, Greece is seen as a country on track to record a public debt to GDP ratio of 135 per cent. A substantial part of the country debt is owed to foreign creditors, with two-thirds of public debt held by foreigners and gross external debt, private and public, estimated at 149.2 per cent of GDP last year. According to reports, Deutsche Bank has estimated that Greece would seek to raise some €31 billion in new borrowing and roll over €16 billion of past debt in the coming year. This suggests that the country is an ideal candidate for sovereign default. Greece is not the only potential defaulter. Italy’s debt to GDP ratio is forecast to rise to 127 per cent next year.

Until recently these figures, which point to the potential for default, were ignored, because stronger economies in the eurozone (like Germany) were expected to bail out partner countries in the event of a crisis. But that is unlikely to happen because of the moral hazard involved. If countries have violated the spirit and letter of the eurozone treaty to get themselves into this difficult situation, rescuing them would only encourage them and others to continue with such practices. In the event, uncertainty builds and investors are paying much money to insure themselves against sovereign defaults. According to the Financial Times, “the volume of activity in sovereign credit default swaps–which measure the cost to insure against bond defaults–linked to the US, UK and Japan have doubled in the past year due to concerns about their public finances.” This is indeed a whole new context in which problems that were considered typical of the so-called emerging markets now plague the metropolitan centres of capitalism. In response, capital is fleeing to safety in emerging markets, leading to stock and property market booms and an appreciation of their currencies–all of which increase fragility in those markets as well.

Borensztein, E., & U. Panizza (2008) The Costs of Sovereign Default, International Monetary Fund, Research Department, Washington, D.C.: International Monetary Fund.
Eaton, J., & R. Fernandez (1995) Sovereign Debt, Cambridge, MA: National Bureau of Economic Research.

(This article first appeared as the H.T. Parekh Finance column in the Economic and Political Weekly dated December 12-18, 2008. )