Tuesday, January 5, 2010

Sentences to Ponder

. Tuesday, January 5, 2010

At least, I've been thinking about them for days:

Sovereign debt defaults look like they will be the next part of the financial crisis, unless you believe that sovereigns are much more constrained now than there were during the 1980s. I'm sympathetic to the constraint view, but I make no claims about debt load analysis, and I am, after all, a lawyer. Anyway, if I'm right, it will be a triumph of international law and international institutions (particularly the World Bank and IMF). If I'm wrong (and many macroeconomists would bet against me), then it will be bad news, etc.

That's David Zaring. Yesterday, Felix Salmon discussed Ecuador's default from last summer.

Sovereign debt defaults have often occurred because of exchange rate volatility, where the debt is denominated in a foreign currency so an exchange rate depreciation can make servicing the debt painful or impossible. But we may be entering an era in which states default on debt that is denominated in their own currency, but in which they have no monetary policy autonomy. Ecuador is a dollarized economy, and I've previously discussed the implications for the eurozone of a Greek default. Has there ever been a series of defaults when the debt is locally-denominated?

Back to Zaring's question, I really don't know if states are more constrained now than in the past. I would doubt it. In fact, to the extent that more states are democratic now than in the past, I would expect more defaults rather than fewer, since political incentives in democracies are to trade off long-run concerns for short-run concerns.

On the other hand, the fragility of the international system and the greater interconnectivity of debt markets might work together to make defaults scarcer. Abu Dhabi recently came to the rescue of Dubai, and it is not inconceivable that the E.U. will work out some sort of bailout with member countries who are in danger of default similar to how the U.S. is working to bail out several of its member states by nationalizing local debt (e.g. California, Illinois). And of course large importing markets will find it somewhat easy to get financing from large exporting markets, so that should prevent any defaults in major economies.

But in general I do expect greater pressure on sovereign debt servicing in the coming year, and I agree with Zaring that it will be interesting to see how that pressure is alleviated.


awolfe said...

Reinhart and Rogoff document a series of local currency sovereign defaults, and argue the "hidden" problem may be a large contributor to the decision to default on external debt. So a series of local debt defaults would not be exceptional, just the norm.

Sentences to Ponder
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