Wednesday, July 21, 2010

Sovereign defaults - the next big thing!

Much of 2008 was marked by a speculation about which big company was to fail next! After the Bear Sterns rescue, people started guessing who was next to disappear - through failure or takeover. Citi, UBS, AIG, Lehman, Merrill were all in the fray. Finally Lehman went bankrupt and Merrill was acquired while the rest survived to see another day. As the fears of a catastrophic global meltdown receded, a certain optimism justifiably took root amongst investors. Not too long though! As Euro area problems boiled over through the PIIGS and a few others, a new specter has started to hang over the global economy - sovereign defaults.

In short sovereign defaults are failures of a government to repay its debt obligations. It is not new to the modern global economy. Argentina defaulted in the 90s, several smaller countries defaulted through second half of 20th century and so on. However it is probably the first time since second world war that some of the developed economies are the candidates for default - in this case most notably Greece and Portugal and to a lesser extent Spain, Italy and Ireland.

Sovereign defaults are imminent when the government of a country runs into debt trap - a state of affairs when one needs to keep borrowing ever increasing debts to simply keep repaying the earlier ones. The obvious reason this starts to happen is because the governments in question spend more than they earn - leading to budget deficits. But then that is the modus operandi of most governments in the present world. Why the sudden change of fortunes? The problems arise when the deficits grow too large for the government's current and expected income as well as when the interest payments go up as the investors in that government's debt start demanding a higher interest rate on their lending. Unfortunately most often these two trends coincide. Investors start to get wary of spendthrift governments - especially those with economies growing slowly or not at all. The increase interest payments on the debt then pushes these governments to start borrowing more, which further unnerves the investors and the cycle continues. Often it is broken in its early stages by belt tightening by government thereby reducing actual deficits as well as by creating more faith amongst investors - thus reducing interest payments on further borrowings.

Will Greece default? Will any of the other PIIGS default? The likelihood of Greece defaulting is low but not insignificant. The likelihood of any others defaulting is indeed quite low. Greece is a much more classic case than the rest, of a government spending too much for its own good with the hope that the buoyant global economy of the pre-2007 era would keep its problems under control. Thus the crisis hit it the hardest. The others are better managed in comparison - though no models of austerity!

While the world worries about the spendthrift governments in southern Europe, there are voices of concern over a frugal Germany as well! It might almost sound contradictory to see experts crow over over-spending and under-spending at the same time for countries in the same monetary union. There is some merit to it, but there are deeper questions raised about the structure of global economy in the process. The rabit-hole may indeed go much deeper, but more on that later!

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