Saturday, March 23, 2013

A Long and Painful History of Sovereign Debt Default

A paper by Michael Tomz of Stanford University and Mark Wright of the Federal Reserve Bank of Chicago looks at the long history of sovereign debt and the risk and repercussions of default.  

The authors begin by noting that sovereign debt was one of the first financial assets that was traded and that this form of borrowing has gone on for hundreds of years.  One of the ongoing problems with sovereign debt is that, unlike private debt, repayment of the borrowed amount is difficult to enforce since there are very few government assets that can be "attached" (i.e. assets that can be frozen to be sold by creditors) in foreign jurisdictions.

How much sovereign debt is there?  Here is a chart showing the history of the face value of all securities and the percentage of those securities that are sovereign debt on the London Stock Exchange, one of the world's largest capital markets for most of the 19th and early 20th centuries:

By 2010, sovereign debt accounted for 19 percent of global financial assets.  Right now, the Economist's Global Debt Clock shows that the total global public debt is just over $50.253 trillion with the world's developed economies having the highest overall debt levels as shown on this map:

First, let’s look at the two greatest risks to countries issuing sovereign debt:

1.) Borrowing funds using bonds with short maturity dates.  Nations that have a high percentage of their debt in short-term bonds are subject to "roll-over" crises where the government is unable to issue new loans to repay maturing ones.  Recent examples include Mexico, Indonesia, Korea, Thailand, Russian and Brazil in the 1990s.

2.) Borrowing funds using foreign currencies.  Between 1979 and 2006, 100 developing countries issued long-term debt in 75 different currencies.  In 2000, almost 70 percent of all debt was denominated in U.S. dollars and 90 percent was issued in USD, Yen, Euros and Deutschmarks. 

Now, let’s briefly answer a series of questions about sovereign debt.

How often do countries default on their debt?  Here is a graph showing the number of defaults from 1820 to 2010 along with the total proportion of those defaulting on their debt in black:

In 176 sovereign entities between 1820 and the present, 80 percent had outstanding debt.  Over that time frame, there were 251 defaults by 107 distinct entities.  The most frequent defaulters were Ecuador, Mexico, Uruguay and Venezuela, each experiencing 8 distinct default episodes.   Ecuador and Honduras have spent more than 120 years in default in total.  Greece has been in default for more than 90 years over the 200 year sample period.  The world's largest default was Greece in 2012.

The solid line on the graph reveals the four episodes in which at least 30 percent of the world's debtor nations have been in default, in other words, a global debt default crisis.  The most recent global debt crisis took place in the 1980s, the first major default crisis since the Great Depression of the 1920s and 1930s.  You will notice that the number of sovereign defaults hit a new record during the debt crisis of the 1980s with as many as 27 nations defaulting in a given year.

What is the probability of a debt default?  The database used for this study suggests that the unconditional probability of a borrowing nation defaulting on its debt is 1.8 percent.  

How long do defaults last?  The mean length of a default across the nearly 200 year sample is 9.9 years and, since the 1970s, is 7.8 years.  The median of all 251 defaults over the study period was 6.5 years.

How much do creditors tend to lose in a default?  Market haircuts (which compares the market value of the settlement to the face value of the defaulted debt) average between 38 and 50 percent with up to an 87 percent haircut for some highly indebted poor nations.

Sadly, many nations find that their debt-to-GDP ratio does not improve after they default on their debt.  On average, a median country ends up with a debt-to-GDP ratio that is 5 percentage points higher in the year of the default and this increase is largest for low income nations.

The debt crisis in Europe seems to be unending and unresolvable, a fact that is not terribly surprising when one puts it into the context of the world’s sovereign debt history.  On top of the ongoing Euro-crisis, we have yet to feel the full brunt of bond market tremors from the seemingly more creditworthy nations of the world including the United States, Japan and the United Kingdom, all of which are experiencing fiscal problems of their own. 

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