Last April we attempted to grade sovereign sustainability risks across the major economies.

No surprise the laggards were (starting from worst) Greece, Ireland, Portugal, and Spain.

After those four, things get much better. The strongest group included (as expected) not just China, Germany, Switzerland, Canada, and Australia, but it also had the US, Japan, and Italy.

The trick to understanding relative sovereign sustainability is to go way beyond the simple ratios of debt-GDP, current account balance, and budget balance. In a long analysis on the history of sovereign defaults, we found that it’s actually major shocks (especially wars), politics, and bad economic policy regimes that have led to defaults rather than simply high debt ratios.

The famous Reinhart and Rogoff book This Time is Different lists the serial defaulters such as Spain, but fails to highlight that nearly all of Spain’s defaults occurred during wars. Meanwhile the UK’s debt-GDP ratio has had a round trip to 250% of GDP and made it back safely well below 100% twice in the past 200 years with no defaults in sight.

Our framework scores countries in three categories:

Structural (international investment position, trilemma regime, inflation sensitivity, terms of trade risk, and whether potential captive savers exist)

Cyclical (gross debt/GDP ratio, financial asset/GDP ratio, interest burden/potential growth, interest rate volatility, hidden short term liabilities, foreign exchange debt, average debt maturity, government revenue to GDP ratio, and gold reserves)

Long-Term (contingent liabilities, entitlement liabilities, and political flexibility)

Admittedly many of these factors are subjective but we took input from our economists and other experts.

Other factors may be unfamiliar but a close reading of the history (see our reading list for where to go for that) suggests things like potential captive savers matter enormously. So often debt crises have come down to the simple matter of can the government force someone to buy its debt or not. Another critical one is trilemma position: there is no example of a large developed economy with a floating currency and independent monetary policy defaulting. Inflation, though, is another matter.

Here are the scores we came up with, and here are links to our original framework piece and our piece on the history of defaults.

This entry was posted by Guest writer on Wednesday, December 1st, 2010 at 17:50 and is filed under Capital markets, People. Tagged with gdp, Greece, ireland, Ken rogoff, portugal, Spain. Edit this entry.