Here Are The 8 Reasons Why Governments Default

Money Black HoleSucks.

Edward Chancellor of GMO LLC has a breakdown of sovereign debt crises in his latest white paper that’s worthy of review.Chancellor, who is a member of GMO’s asset allocation team, writes on when and why governments encounter default. He spells out 8 reasons that can drive them to this conclusion. Chancellor does not claim that any of these reasons necessitate a default, instead he shows historical examples of when they have caused such a scenario.

This is required reading for everyone trying to understand what is sure to be several years of sovereign debt worry.

1. A reversal of global capital flows

Since 1800, there has been an irregular ebb and flow of sovereign lending. The cycle goes something like this. During booms, money is disbursed from the financial centres to countries at the periphery, which promise higher rates of return. The good times don't last. A panic in London or New York, often caused by a bank failure, staunches the flow of international credit. Trade is interrupted. Commodity prices fall, reducing the export earnings of peripheral economies. The world economy turns down. Foreign borrowers find themselves unable to either service their debts or refinance them. They default.

Reinhart and Rogoff find that sovereign defaults tend to pick up after banking crises and peaks in the capital flow cycle. This pattern of boom and bust in government lending was first evident in the 1820s, when newly independent Latin American republics raised funds in the London money market. A severe financial panic in the City of London at the end of 1825 brought this lending spree to an end. All of the Latin American loans raised in this period defaulted.

This cycle of the rise and fall of international lending, followed by sovereign default, was repeated in the 1870s, 1930s, and 1980s. For instance, the collapse of Austria's Creditanstalt bank in the summer of 1931 was followed by bank failures and ultimately sovereign debt crises across central Europe.

Source: CMO White Paper

2. Unwise lending

3. Excessive foreign debts

4. A poor credit history

5. Unproductive lending

6. Rollover risk

National debts are scarcely ever repaid. They are rolled over. As long as the capital markets remain open and a government's credit holds good, there's no problem. However, when the debt is largely short term, there's an increased market risk. This problem was particularly acute before the development of modern bond markets in the seventeenth century. Habsburg Spain was continually caught short by an excessive dependence on short-term financing. The Emperor Philip II's default in 1557, which sparked the first international credit crisis, occurred at a time when short-dated debt was 3.5 times the imperial net revenues.

Source: CMO White Paper

Photo: Philip II

7. Weak revenues

Reinhart and Rogoff estimate that, on average, public debt grows by around two-thirds in the years immediately following a banking crisis. They also find that the aftermath of banking crises is generally followed by prolonged periods of below average economic growth. As a result, tax receipts are lower than normal. An incipient fiscal crisis can be solved if the government takes action to either reduce its spending or raise revenues. However, there may be little public appetite to endure the austerity of public spending cuts and no consensus on tax increases. The collapse of Louis XVI's government, which ushered in the French Revolution, was largely the result of a fiscal crisis that originated in the state's inability to raise sufficient taxes to pay its debts.

Source: CMO White Paper

Photo: Louis XVI

8. Rising interest rates

One of the consequences of short-term debt is that creditors are able to raise rates rapidly in response to changing perceptions of credit risk or rising inflation. Rising risk premiums on government loans may lead directly to state bankruptcy. Philip II, for instance, was paying nearly 50% annual interest on his new loans prior to 1557. The French government in the late eighteenth century found itself borrowing at twice the cost of its great rival, England. Higher interest charges on floating rate bank loans were a major factor behind the Third World Debt Crisis of the 1980s.

Source: CMO White Paper

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