How to Default on Sovereign Debt

In December 2001, the Government declared default on its external debt.

True, the country s periodic debt crises are often the result of self destructive macroeconomic policies. But, this time, the default has been triggered by a significant shift in the international sovereign debt regime.

This approach has several advantages by leaving the face value of the debt unaltered, EU officials could argue that restructuring Greece s debt did not amount to a default, thereby limiting contagion. European banks holding Greek government debt could keep pretending that it is worth its full value.

If you deliberately aim to shrink your GDP, your debt to GDP ratio is bound to grow. The only way to cut your debt (other than by default) is to get your economy to grow.

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In countries that cannot issue debt in their own currency (traditionally emerging market economies), or that issue debt in their own currency but cannot independently print money (as in the euro zone), unsustainable fiscal deficits often lead to a credit crisis, a sovereign default, or other coercive form of public debt restructuring.

In countries that borrow in their own currency and can monetize the public debt, a sovereign debt crisis is unlikely, but monetization of fiscal deficits can eventually lead to high inflation. And inflation is like default a capital levy on holders of public debt, as it reduces the real value of nominal liabilities at fixed interest rates.

In the eurozone, Ireland, Greece, Portugal, and Cyprus all had to restructure their sovereign debt to avoid outright default. Rising debt GDP ratios cast a pall over fiscal policy, and became the main justification for austerity policies that prolonged the slump.

The fact is that Greece had no right to borrow from German or any other European taxpayers at a time when its public debt was unsustainable. Before Greece took any loans, it should have initiated debt restructuring and undergone a partial default on debt owed to its private sector creditors.

Lately, concerns about America s unsustainable fiscal deficits have, likewise, resulted in ugly political infighting, almost leading to a government shutdown. A similar battle is now brewing about America s debt ceiling, which, if unresolved, introduces the risk of a technical default on US public debt.

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The government bonds of peripheral eurozone countries thus became toxic. Given the unprecedented nature of the Greek default, the market valuation of peripheral debt has been fluctuating widely, still searching for fundamentals, such as deficit or debt levels, that could explain the evolution of risk premia over time.

The eurozone sovereign debt crisis appears to have been the worst managed financial crisis since Argentina s default in 2001. The European Union and eurozone leaders have seriously discredited themselves.

As for Europe, the Kirchner s have not yet paid off Argentina s debt pending since the default to the Paris Club of sovereign creditors. All of this hinders foreign investment and access to international credit.

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In other words, private markets need to be convinced both that there is a low probability of default (hence the importance of credible plans), and that there is some additional loss bearing capacity in the new funding, so that, if there is a default, outstanding or rolled over private debt does not have to bear the full brunt.

But the stimulus measures transformed a banking crisis into a fiscal and sovereign debt crisis. From 2010 onwards, governments started to raise taxes and cut spending in response to growing fears of sovereign default.

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LONDON Everyone knows that Greece will default on its external debt. The only question concerns the best way to arrange it so that no one really understands that Greece is actually defaulting.

Moreover, many banks had so much public debt on their balance sheets that they would have been bankrupted in the event of a full blown default. This led to extreme instability in the eurozone s banking system.

NEW YORK The Greek euro tragedy is reaching its final act it is clear that either this year or next, Greece is highly likely to default on its debt and exit the eurozone.

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A vicious circle of public finance deficits, current account gaps, worsening external debt dynamics, and stagnating growth can then set in. Eventually, this can lead to default on euro zone members public and foreign debt, as well as exit from the monetary union by fragile economies unable to adjust and reform fast enough.

A Latin American default would have brought down the banking systems of all the major industrial countries, causing something like a replay of the Great Depression. Exposure to Mexican debt alone represented some 90 of the capitalization of major US banks.

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