In the wake of Greece, a short history of debt defaults

Now that Greece has missed a €1.5 billion (£1.1 billion) payment to the International Monetary Fund, due on June 30, debt markets are facing something highly unusual — a default by an advanced nation.

The world is coming out of a period of historically low levels of default. Since the Latin American crises of the 1980s, bond markets have enjoyed decades of relative calm, as the chart below from the Bank of Canada illustrates:

That, however, could be set to change as the world struggles under heavy debt burdens in the aftermath of the Global Financial Crisis.

So what can we expect from this period?

Well the first, and more important, point to note is that it is not only the frequency of defaults that has shifted over time but also the composition of them.

As you can see from the chart below, official creditors (including central banks, central government departments and agencies, government-controlled institutions other than commercial banks, and international institutions) have taken a greater share of the burden of defaults over time. The most recent event was the 2013 restructuring of official sector loans to Greece, Portugal and Ireland agreed by creditors:

Why has the shift of pain from the private sector to the public sector occurred?

Sovereign defaults, especially in advanced economies, can be hugely disruptive events for financial markets that use government-issued debt as a benchmark measure for risk-free rates (effectively pricing in a close-to-zero chance of default).

The Latin America crises, caused in large part by the oil price spike of 1973 providing a cash windfall for commodity exporters. A number of governments in these countries, especially large economies in South America, took advantage of the situation to borrow heavily in international financial markets in order to fund industrialisation and infrastructure.

However, a combination of a further oil shock in 1979-1981, the consequent sharp rise in interest rates in the US and Europe, and the global recession that followed meant that servicing the huge debt burdens governments had taken on became impossible.

The result? Huge pain for commercial banks as they were compelled to take losses on bad loans.

The aftermath was far from painless for the countries involved as well. As Ben Bernanke pointed out, defaults left much of South America cut off from international credit markets. This, in turn, meant that “currencies were sharply devalued as current accounts were forced to adjust, rising fiscal deficits were again financed by money creation, and inflation soon rose to new heights”.

However, after undergoing deep economic reforms in the early 1990s much of the region emerged in a stronger position to grow again unencumbered by the financial folly of the past.

Contrast this with Europe’s experience since the onset of the financial crisis in 2008. Once again governments were able to sustain relatively high debt levels over the boom years, as the creation of the single currency allowed smaller countries to borrow at lower interest rates on the (flawed) assumption that their debts were fully backed by larger neighbours.

This convergence ended abruptly when it became apparent to financial markets that the support for struggling countries by fellow eurozone countries was limited and conditional — sending interest rates in Europe’s periphery soaring and forcing smaller countries such as Greece, Ireland and Portugal into debt crises.

Sadly for those seeking a moral lesson, it was not really a tale of reckless governments borrowing to provide rocket fuel to unsustainable economic booms. Most countries in the Eurozone’s periphery had, what looked like, sustainable debt-to-GDP trajectories if you extrapolated from their pre-crisis trend growth, low interest rates and government debt burdens, encouraging them to borrow and creditors to lend.

Yet, rather than letting the banks take the pain, as they had done in the 1980s, fearing contagion spreading across the region from a loss of confidence the official sector institutions allowed a large proportion of troubled countries’ debt transferred to official creditors including the European Central Bank, the IMF and other Eurozone governments.

The IMF’s own analysis suggests that there could be more pain to come, whatever the result of Greece’s referendum on Sunday. The Fund estimates that in order for Greek government debt to shift onto a sustainable path under the package of reforms proposed by the country’s creditors, it will require “at least

€36 billion” of new European money on “highly concessional terms”.

Even then, the likelihood that Greece’s public finances will be put onto a sustainable footing without some outright reduction in its debt burden remains highly uncertain. If growth disappoints and creditors elect to ease their demands for the Greek government to deliver on its primary surplus target of 3.5% by 2018 it could require “full write off of the stock outstanding in the GLF facility (€53.1 billion)”.

Judging by the relatively modest response in European sovereign bond spreads to the country falling into IMF arrears, it seems the risk of contagion in financial markets has been successfully contained this time around (at least for the moment). However, signs of political fallout from the referendum could well shift that dynamic.

There are few signs that Greece’s problems will inevitably usher in a period of increased frequency of other sovereign defaults but that does not mean there aren’t lessons to be drawn. One of the most important can be found in Carmen Reinhart and Kenneth Rogoff’s observation that people had come to believe “countries do not need to resort to the standard toolkit of emerging markets, including debt restructurings and conversions, higher inflation, capital controls and other forms of financial repression”.

That, Reinhart and Rogoff state, is “at odds with the historical track record of most advanced economies.” Instead history shows countries have relied on debt restructurings, inflation and financial repression in the past as key tools to escape from debt crises.

It is perhaps a lesson that is worth re-learning.

Author: Tomas Hirst is a contributor to the World Economic Forum’s Agenda.

Image:  A ballot reads “Not approved, No” (above R) and “Approved, Yes” (bottom R) at an Athens high school that will be used as a polling station for Sunday’s referendum in Greece. REUTERS/Alkis Konstantinidis