How to Default on Sovereign Debt

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.

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.

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.

Sovereign Debt at Square One

Sovereign debt restructurings with private creditors

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.

A New Approach to Eurozone Sovereign Debt

The Root of All Sovereign Debt Crises

If Europe could show in the worst possible scenario of sovereign default how such a process might operate, uncertainty would be reduced and markets would be reassured. And, in the longer term, we would have a viable international model of how to tackle severe sovereign debt problems.

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.

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

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.

One of the key challenges is the negative feedback loop between the weaknesses of many banks and the doubts about the peripheral countries sovereign debt. The sovereign debt and banking crises have become even more closely interlinked as banks bought greater amounts of their home countries sovereign debt.

Table 3 Recent sovereign debt restructurings with private creditors main features

But fiscal stimulus is constrained within the eurozone, where member countries no longer issue their own currency and sovereign debt therefore carries a default risk. Aggressive monetary expansion through quantitative easing is also far more complicated and politically contentious in a currency area with no federal debt for the central bank to buy.

15. Reiterates the importance of the orderly resolution of sovereign debt crises, notes the increasing voluntary use of collective action clauses in international sovereign bonds, and takes note of the efforts led by sovereign debtors and private creditors to develop a voluntary code of conduct for the resolution of sovereign debt crises

When financial markets discovered that supposedly riskless government bonds might be forced into default, they raised risk premiums dramatically. This rendered potentially insolvent commercial banks, whose balance sheets were loaded with such bonds, giving rise to Europe s twin sovereign debt and banking crisis.

Traditionally, sovereign risk has been concentrated in emerging market economies. After all, in the last decade or so, Russia, Argentina, and Ecuador defaulted on their public debts, while Pakistan, Ukraine, and Uruguay coercively restructured their public debt under the threat of default.

Schauble advocates a longer term solution a European Monetary Fund (EMF) to provide emergency lending to countries at risk of default on their sovereign debt. Emergency lending would come with a prohibitive price tag, strict conditions, and mandatory penalties in the event of non compliance.

Noted the request of Iraq for the cancellation or reduction of their sovereign debt.

Only a year ago, at the IMF s annual meeting in Washington, DC, senior staff were telling anyone who would listen that the whole European sovereign debt panic was a tempest in a teapot. Using slick PowerPoint presentations with titles like Default in Today s Advanced Economies Unnecessary, Undesirable, and Unlikely, the Fund tried to convince investors that eurozone debt was solid as a rock.

The solution to breaking the nexus between sovereign debt crises and banking crises is straightforward limit banks to lending where evaluation of borrowers willingness and ability to repay isn t a great leap in the dark. This means no cross border sovereign debt (or esoteric instruments, such as collateralized debt obligations).

If Spain and Italy do look sound enough at the end of two years, European political leaders can allow Greece to default without fear of dangerous contagion. Portugal might follow Greece in a sovereign default and in leaving the eurozone.

The first has to do with economic and financial risks. Ditching the euro might trigger a banking crisis, capital flight, inflation, and perhaps even sovereign default.

Indeed, Argentina s sovereign default happened almost simultaneously with the demise of the currency board, but corporate renegotiations were a protracted affair. Eventually, most companies avoided bankruptcy, mainly owing to the fourth ingredient in Argentina s exit toolkit capital controls that provided the legal umbrella to stop external corporate debt servicing.

When a sovereign decides that its foreign debt is unsustainable, the government and its creditors have had to negotiate among themselves about what to do. For sovereign bonds held by other sovereigns, the Paris Club of creditor countries has developed procedures for handling the debt.

In the event of sovereign defaults, moreover, the cost of bailing out the banks may far exceed the cost of issuing Eurobonds or instituting a reasonable transfer regime. Investors need to be reassured that debt service costs are under control, and that debt volumes and deficit limits are firmly monitored in order to minimize default risks and strengthen banks ability to lay the groundwork for sustainable growth.

Recognizing the current debate on sovereign debt restructuring, especially the efforts led by sovereign debtors and private creditors to develop a voluntary code of conduct, and stressing that modalities for sovereign debt restructuring should be voluntary, market friendly and flexible, with due consideration of the specific circumstances of individual countries, and should result from the participation of all relevant stakeholders,

(f) continue deliberations on the creation of a framework to deal effectively with all sovereign debt of developing countries.

More broadly, the ECB s marginal lending facility is an indirect means of monetizing sovereign debt. It is an even less direct way to address the private, related debt overhang.

Finally, GDP indexed bonds and other tools for dealing sensibly with unsustainable debt could be applied exclusively to member states debt not covered by the program and in line with international best practices for sovereign debt management.

Nonetheless, Argentina s latest debt trauma shows that the global system for sovereign debt workouts remains badly in need of repair. Deepening domestic debt markets and perhaps change along the lines proposed by the IMF is sorely needed.

Their economies are still tumbling, and the debt continues to grow. The credit ratings agency Standard Poor s has just downgraded the sovereign debt ratings of nine eurozone countries, including France.

The credit ratings agency Standard amp Poor s has just downgraded the sovereign debt ratings of nine eurozone countries, including France.

As Greek officials consider their options, they would do well to bear in mind that there are better and worse ways to default on sovereign debt especially given countries desire to reestablish their creditworthiness as soon as possible. In the coming weeks and months, the Greek government would be wise to consider three guidelines

Meanwhile, governments were running large deficits a legacy of the economic downturn which renewed growth was supposed to shrink. In the eurozone, countries like Greece faced sovereign debt crises as bank bailouts turned private debt into public debt.

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.

The international community has, so far, failed to develop effective and equitable arrangements for restructuring sovereign debt, despite the clearly dysfunctional and problematic consequences of past international public debt crises. This prevents timely debt workouts when needed, effectively impeding recovery.

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.

Regardless of how the current impasse is resolved, the ruling raises many questions for issuers and holders of sovereign debt. If creditors now believe that holding out makes it more likely that they will receive full value at a later date, restructuring sovereign debt and restoring a debtor economy s normal functioning will be more difficult.

Until the euro crisis, it was generally believed that problems servicing sovereign debt occurred only in emerging markets and the least developed countries. The US Supreme Court s decision on Argentina adds a new wrinkle, and may well further increase the risk attached to holding sovereign debt and this to the cost of issuing it.

This distinction between foreign and domestic debt is particularly important in the context of the euro crisis, because eurozone countries cannot devalue to increase exports if this is required to service foreign debt. And the evidence confirms that the euro crisis is not really about sovereign debt, but about foreign debt.

We welcome the commitment of the Paris Club to reduce substantially Iraq's sovereign debt and urge the other creditors to take similar decisions.