The IMF recently published the final part of its sovereign risk trilogy.
Parts 1 and 2 were dark and quite frightening for investors, but Part 3 “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely” was positively sunny.
Although the fiscal fundamentals look challenging, current market indicators of default risk seem to reflect some market overreaction. The key considerations are the following:
- The needed fiscal adjustment is difficult, but has been attained before.
- Default would not reduce the need for adjustment by much, because primary deficits, not the interest bill, are the problem in advanced economies today.
- Although marginal interest rates are now high for Greece and, to a lesser extent, other European peripherals, average interest rates remain relatively low, giving time for fiscal adjustment to convince markets.
- Countries do not strategically decide to default but do so in the midst of refinancing crises: in the past, advanced economies that reduced primary deficits and reached primary balance or a small primary surplus subsequently persevered with the adjustment.
- The political and economic costs stemming from a hypothetical default would not be lower than those incurred under a strategy based solely on fiscal adjustment.
- Reforms are needed to improve potential growth and external competitiveness, thereby easing the fiscal adjustment process.
Unlikely? Try telling that to Morgan’s Stanley’s Arnaud Marès, who wrote this week that it is not question of whether sovereigns will default but how.
Or to SocGen’s Ciaran O’Hagan, who is puzzled by this IMF diatribe.
The DUUU is the perfect antidote for the other papers (why the IMF’s economists couldn’t agree on just one cohesive paper beats us). But an agenda with a clear axe to grind is unusual for IMF research. What is usual for a diatribe (even at the IMF) is that it cuts corners.
We’d be reticent to dismiss public default out of hand. One reason is that we have already seen it. We have already had defaults in state debt from e.g. “IOUs”3, and in agencies4create inflation, as suggested by the IMF itself some months ago, even if they haven’t impacted directly most investors. Defaults can occur in many ways. One of course is to (its chief economist no less). Some of the defaults can be peculiar e.g. when the USA changed the indexation of its gold bonds. Or they can be dressed up as wolves in the clothing of sheep e.g. swaps of equity for debt. Anyway, default is here, and is probably not going away anytime soon.
Quite.
And O’Hagan continues the attack.
The DUUU authors cites academics that claim sovereigns don’t like defaulting. But more recent research, with the benefit of recent experience, suggests that reputation may count less now for sovereigns. Moreover “postdefault spreads return to predefault levels within twenty-four months or less” and there is “little evidence of exclusion from markets”. And little effective peer pressure to keep recalcitrant sovereigns in check.
Default can make sense, and can even benefit sovereigns. An Irish default on some of its state owned bank debt after 29 Sep9 We see little sovereign crises as playing out over many years (when the state guarantees expire) actually could benefit the sovereign (if properly managed). In late 2008, we saw a massive transfer of costs and risks from defunct banks to the taxpayer. That hurt sovereigns. Reversing that move can now benefit them.
Now, there’s a suggestion.
Related link:
How to think about a sovereign debt crisis – FT Alphaville
Ireland’s exteeeeended banking issues – FT Alphaville
Greece debt default seen as ‘unlikely’ – FT