Sovereign default in the core?
optimism that the world economy is well set on the road to recovery
has now been dampened by turmoil and uncertainty in the financial markets.
The cause for concern is that some heavily indebted countries in the
Middle East and
declaration by the government-owned conglomerate Dubai World late November
that it proposed to unilaterally suspend payments due on its large debt
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
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 payment requirements, buying time today and leaving it to future parties in power to deal with the consequences. This possibility flagged 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, as the current crisis involving Portugal, Italy, Ireland, Greece and Spain (the so-called PIIGS) exemplifies.
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 payment 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 is seen as ensuring that creditors do lend to governments.
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
often defaults in developing countries occur when they have been the
targets of a lending boom. One such boom preceded the debt crisis in
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 International Monetary Fund (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.'
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% or more of GDP as they do in
economy in the eurozone which is the focus of attention is
recently these figures, which point to the potential for default, were
ignored, because stronger economies in the eurozone (like
Chandrasekhar is a Professor at the Centre for Economic Studies and
E., & U. Panizza (2008) 'The Costs of Sovereign Default', International
Monetary Fund, Research Department,
J., & R. Fernandez (1995) 'Sovereign Debt',
*Third World Resurgence No. 234, February 2010, pp 15-16