Greece has been in default more than 50 per cent of the time since independence. In this post, I note that sovereign debt defaults are not unusual, and can be an important part of the rebalancing process.
For more back ground on this issue, you can also read my previous posts:
Greece is going to come back into the splotlight (May 2011)
Greece – The fire is out, but there are still problems (May 2010)
Some respite from European sovereign debt concerns
The markets have spent much of the past few months worrying about the risk of a sovereign debt default.
A sovereign debt default means that a government (like a company or individual) isn’t able to meet its obligation to pay interest and capital when due.
A key risk here is panic spreading to other countries and markets seizing.
The recently announced ‘bailout’ package for Greece marks a likely turning point in this ongoing story.
It includes elements of a negotiated default, or rescheduling process, that reduces Greece’s overall debt burden, while also providing enhanced support measures for other troubled European countries.
The real breakthrough is that it spreads the pain –most lenders are now willing to accept a loss on their exposure.
While this is a positive development that has calmed the markets, the underlying problems facing Europe are still far from solved.
High deficit and debt situations take a long time to correct
The problem for many European countries, not just the European periphery, is that they are dealing with very high deficit and debt levels, as shown by figure 1.
To ease this situation, these countries need to reduce their deficits to sustainable levels. There are only two ways this can occur: the first is by increasing income and the second is by decreasing spending.
In practice this is very hard to do, and it takes a long time when the starting points are so high.
In the case of Greece, it’s almost impossible because the country is effectively bankrupt and already experiencing recessionary conditions.
This is largely why a workable solution for Greece still requires external help.
Figure 1: European govern deficit and debt levels
Source: International Monetary Fund. AMP Capital Investors. As of May 2011
The trade-off European leaders grappling with
European authorities have been grappling with the trade-off between governments reducing deficits and avoiding potential defaults.
The trade-off is seen to be:
• Reducing deficits = slowdown / recession and social / political problems
• Default = slowdown / recession and higher interest rates / locked out of markets and contagion
Up until now, the possibility of a managed, orderly default has been off the table because European authorities see the risk of contagion as too high.
But in practice you can’t dodge the issue – markets transmit risks and concerns quickly.
This was highlighted in recent weeks with the markets driving up yields on Italian debt to their highest levels in a decade, even though Italy is economically sound, and has longer-term debt duration than other European countries.
The spill over of tension into Italy partly accounts for the change in sentiment among European Leaders for the private sector to accept some loss on their exposure.
Overall, this is a positive development that has been well received by the markets. But there is still a lot of detail to work through, and the rating agencies could unsettle the markets if they regard the latest instalment of support measures as a technical ‘default’.
Historically, sovereign debt defaults not unusual
It may come as a surprise to learn that historically, sovereign debt defaults are not unusual.
Research shows there have been 246 sovereign debt defaults since 1900. (Reinhart & Rogoff, This Time is Different These defaults typically occur in waves and are separated by many years, or decades, which make these events seem rarer than what they are.
In fact, Greece has spent 50.6 per cent of its time in default or in a process of rescheduling since it gained independence in 1829.
Many government defaults tend to occur after a large scale financial crisis, such as the GFC. Most are managed in an orderly way, but the impact for investors is a period of very slow growth that lasts between five to ten years.
What about the US?
The US is also in the headlines because its deficit and debt levels are very high.
The US places a legal limit on how much the government can borrow. Every few years, this limit gets reached and Congress is asked to approve an increase.
This time they are playing hardball, and the markets are likely to be spooked further if it takes up to the eleventh hour for an agreement to be reached.
In contrast to Greece, the US is not bankrupt. Its deficit is due to the massive stimulus measures that were deployed at the onset of the GFC.
Another key difference is that the US dollar still remains the global reserve currency, which has been allowed to depreciate, while Greece is tied to the Euro.
In addition to these factors, US government debt is seen as a safe haven in times of risk, but this may change if the government doesn’t outline credible exit strategies to manage and reduce current debt levels.
What this means for investors?
Government debt levels will continue to disrupt markets until balances become more manageable. This is likely to take a long time and involve a period of very slow growth.
The processes of avoiding, or managing a default may be unnerving at times, but history suggests that markets will eventually climb over the disruption. There is always the risk of a mis-step and markets are currently pricing in much of this concern.
A big lesson from the GFC is to ensure that cash is set aside for cash and liquidity needs. That security needs are met and that longer-term strategies, where appropriate, take advantage of historically cheap markets.
