Thursday, January 29, 2009

Defaults on government debt - starting now?

Economist Brad Delong has put together an excellent compendium of academic papers to illustrate the history and relevance of past financial crisis.

The one I found most interesting wasn't on the list "This time it's different - A panoramic view of 8 centuries of financial crisis."

This long (125 page) paper looks mainly at sovereign debt defaults. The following summarises my reading of it and it’s relevance for the current situation.

1. Very high default rates across all regions in all time periods apart from short lulls of a decade or two.
2. In situations were gov debt is domestic rather than external there is still default on external debt - this seems contrary with IMF views.
3. Defaults in countries happen in waves and generally flow big decreases in commodity prices that impact these "emerging
4. There are also peaks in defaults after there have been large financial flows from eh financial centers to the "emerging" economies. I.e. the money is spent then the flow stops and then the defaults occur.
5. There is particularly high inflation in the defaulting countries during and after defaults. I.e. the gov inflates to reduce indebtness
6. Inflation crises and exchange rate crisis go hand in hand.

To me, the current situation is a classic illustration of a typical scenario just before a large wave of defaults occur. I.e we have had the prerequisite large capital inflows (which are now rapidly drying up or reversing) and the collapse of commodity prices. The fact that much of the debt is local rather than external is no protection.

This also suggests we are going to have high inflation and big drops in exchange rates in the emerging commodities that have been impacted.

The difference this time seems to be that the largest capital flows have been into what most would consider the financial centre (US). This may change the dynamics of things but I don't think it will change the sovereign debt defaults in many emerging markets.

If this does occur this is going to cause:
1. Serious stresses on governments in non defaulting countries supporting bailout efforts in other countries through the IMF etc
2. Defaulting countries will be unable to support their own economies during the current downturn – indeed the usually proscribed austerity packages will exacerbate the issues given the global downturn and the difficulty of exporting your way out of the crisis when export markets are very weak.
3. Geopolitical tensions, due to the battle between debtors and creditors over repayment schedules, austerity packages etc.
4. Political instability in defaulting nations.
5. Further strains on the solvency of the banking systems in a wide range of countries (US Europe Asia etc) as more bad loans are written off.
6. A great deal of suffering in countries with high poverty levels.

Clearly a rather worrying picture on top of the current problems in private markets.

From a trading perspective the best options here would appear to be to short emerging currencies that have significant government debt and "commodity" exports over the coming few years. I'll talk more about the implications of this and any early signs of a wave of defaults occurring in a follow up blog.


  1. Hi Steve,

    I found your blog via the grasping reality with both hands blog. Thanks for recommending the 125 page paper on sovereign debt defaults. Its a great read. Actually, if you get a chance take a look at my blog Its dedicated to making intelligent investors and traders more well rounded. I love posting soros, behavioral finance, and psychology related material.

    Best Regards,
    Miguel Barbosa

    miguel @

  2. Thanks Miguel - great to hear from someone with some common interests - will check out your blog!


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