Many assume that a sovereign default is an unusual event. After all, even Greece did not default (yet!).

Below is an interesting article from Calculated Risk that puts sovereign defaults into perspective. As can be seen, they are not unusual and not infrequent. Furthermore, they tend to cluster in various time periods. The 1930s were one of those periods. Likewise, the first 5 years of the 1980s saw in excess of 60 countries default. Whether there is some linking that causes a domino effect is moot, but appears to be likely.

The U.S. is subject to the same forces that cause other countries to default. Eventually, it will default in the sense that it will not honor its commitments. Whether that involves a repudiation of funded debt or just reneging on the social welfare state remains to be seen. Mathematically, it is not possible to service the commitments undertaken. The problem is no different for the social welfare states of Europe.

Drastic changes in the social programs are necessary in order to survive. I suspect these will not be made proactively. It will take an economic crisis of major proportion before the political class will summon the will to do what is necessary. That will likely occur some time between the end of this day and ten years.

Part 2. How Often Have Sovereign Countries Defaulted in the Past?

by CalculatedRisk on 7/10/2010 08:30:00 AM

CR Note: This is part 2 in a series on sovereign debt issues by reader “some investor guy”. Here is Part 1: How Large is the Outstanding Value of Sovereign Bonds?

Sovereign bonds have been defaulting for almost as long as there have been sovereign bonds. The problems go back many centuries. A good overview created for the IMF is “The Costs of Sovereign Default” by Eduardo Borensztein and Ugo Panizza. Some countries are “serial defaulters”, with a long history of sovereign defaults. Many have defaulted on sovereign debt five times or more.

Click on graph for larger image in new window.

Here is a chart showing the number of countries defaulting each year from 1824 to 2003. The raw data comes from S&P. Charts were created by the Some Investor Guy.

As you can see, there are some years with no defaults at all, and other years with many. Defaults tend to come in clusters, and the behavior of lenders often changes substantially after defaults. In the Volatility Machine, Michael Pettis asserts that sovereign default contagion follows predictable patterns, and that contagion is primarily due to investors in the first defaulting country also having investments in other countries which are vulnerable. This is especially the case with leveraged investors.

In the seemingly “quiet period” from 1945 to 1959, there was just one sovereign default. Interestingly, this was also a time with a number of very angry foreign investors. This time period was the peak of expropriation of foreign assets. There were at least 25 nationalizations and expropriations of foreign assets. Many were by new members of the Soviet Bloc, and by newly independent colonies (Source: Michael Tomz, Stanford, working paper).

For you ubernerds who want to see which countries defaulted each year, here they are. I’ve broken them down into three periods to make the charts more readable.

1820 to 1920(click on chart for larger image)

1920 to 1980

1981 to 2003

The underlying causes of default (such as rises in interest rates, wars, commodity price collapses, and simply borrowing too much money) have been diagnosed for many episodes. Proximate to the default, any of the following six financial changes might occur:

1. Government revenues fall far below history or forecast;
2. Expenses aside from debt service rise far above history or forecast;
3. Interest rates rise substantially; due to inflation, credit spreads, illiquidity, or other causes
4. Demand for bonds suddenly drops or disappears (a sudden stop);
5. Exchange rates move, making payments on foreign denominated bonds much more expensive (currency risk), and,
6. A government simply decides not to pay, even though it has the capacity to pay (repudiation).

Paolo Manasse and Nouriel Roubini studied sovereign default risk and concluded that many guidelines used for estimating when default was likely did not perform well, primarily because those guidelines looked at separate risks. For example, total government debt exceeding 200% of GDP is often used to indicate stress. However, some other circumstances may make the problems much less severe (like having a growing economy and no foreign denominated debt). Other factors might make it much worse (like high inflation).

CR Note: This is from “Some investor guy”. Over the next week or so, some investor guy will address several questions: What are market estimates of the probabilities of default? What are total estimated losses on sovereign bonds due to default? What happens if things go really badly and what are the indirect effects of default?Here is Part 1: How Large is the Outstanding Value of Sovereign Bonds?Next in the series, Part 3. What are the Market Estimates of the Probabilities of Default?

Posted by CalculatedRiskon 7/10/2010 08:30:00 AM118 Comments