The Costs of Sovereign Default: Theory and Reality
Eduardo Borensztein and Ugo Panizza
Inter-American Development Bank / UNCTAD -HEID
November 9, 2010
For the last 50 years sovereign defaults only concerned developing and emerging countries. The recent predicaments of Greece have raised the specter of a default in a high-income OECD country belonging to the Euro Area. What would be the outcome of such an event?
Sovereign debt is different
Sovereign debt is different from private debt because creditors do not have a well defined claim on the sovereign's assets. The lack of a procedure for enforcing sovereign debt contracts is partly due to the principle of sovereign immunity. However it also relates to the fact that, even when creditors obtain a favorable ruling, they cannot attach assets which are located within the borders of the defaulting country, and in fact have had limited success in going after assets located abroad (for a detailed discussion see Inter-American Development Bank, 2006 and Panizza, Sturzenegger, and Zettelmeyer, 2009).
Since contracts cannot be enforced, why do sovereigns repay and why do lenders lend? The economist's natural answer is that it must be the case that repaying is cheaper than defaulting. But what are the costs of default? In a seminal paper that kick-started the sovereign debt literature, Eaton and Gersovitz (1981) focused on reputational costs and showed that, under certain conditions, the threat of permanent exclusion from financial markets is a sufficient condition for repaying. Successive work by Bulow and Rogoff (1989) emphasized the possibility of trade sanctions. Cole and Kehoe (1998) showed that positive lending can be sustained even if creditors cannot punish defaulting countries. In this class of theoretical models incentives to pay come from the fact that a default would reveal negative information about the government to other parties that are engaging in transactions with the defaulting government.
Measuring the costs of default
In a recent paper (Borensztein and Panizza, 2009), we look at four possible costs of default: loss of reputation, reductions in trade, costs to the domestic economy, and political costs.
We start with reputational costs and show that defaulting countries do indeed suffer in terms of access to the international capital markets. Default episodes are associated with an immediate drop of credit rating and a jump in sovereign spreads of approximately 400 basis points. However, this effect tends to be short lived and disappears between 3 and 5 years after the default episode.
When we look at trade costs, we corroborate Rose's (2005) result that default episodes are associated with a drop in bilateral trade, but we are not able to indentify the channel through which default has an effect on trade. In a companion paper (Borensztein and Panizza, forthcoming), we also find a trade effect using industry-level data but, again, we find that the effect tends to be short lived and only lasts 2 to 3 years.
When we explore the effect of default on GDP growth, we find that, on average, default episodes are associated with a decrease in output growth of 2.5 percentage points in the year of the default episode. However, we find no significant growth effect in the years that follow the default episode. In fact, quarterly data indicate that output contractions tend to precede defaults and that output starts growing after the quarter in which the default took place (Levy Yeyati and Panizza, forthcoming). This suggests that the negative effects of a default on output are likely to be driven by the anticipation of default.
While economic models often assume that policymakers have the incentive to default too early or too often, in the real world politicians and bureaucrats go to a great length to postpone what seems to be an unavoidable default. In the case of Argentina, for instance, even Wall Street bankers had to persuade the policymaking authorities to accept reality and initiate a debt restructuring (Blustein, 2005).
There are two possible reasons for this reluctance. The first relates to the fact that default episodes seem to have high political costs. We find that, on average, ruling governments in countries that defaulted observed a 16 percentage point decrease in electoral support. We also look at changes in top economic officials and show that in any given tranquil year there is a 19 percent probability of observing a change in the finance minister, but after a default episode the probability jumps to 26 percent. The presence of such political costs has two implications. On the positive side, a high political cost would increase the country’s willingness to pay and hence its level of sustainable debt. On the negative side, politically costly defaults might lead to ‘‘gambles for redemption’’ and possibly amplify the eventual economic costs of default if the gamble does not pay off and results in larger economic costs.
It is also possible that policymakers postpone default to ensure that there is broad market consensus that the decision is unavoidable and not strategic. This would be in line with the model in Grossman and Van Huyck (1988) whereby ‘‘strategic’’ defaults are very costly in terms of reputation—and that is why they are almost never observed in practice—while ‘‘unavoidable’’ defaults carry limited reputation loss in the markets. Hence, choosing the lesser of the two evils, policymakers would postpone the inevitable default decision in order to avoid a higher reputational cost, even at a higher economic cost during the delay. If this interpretation is correct, a third-party institution that can sanction when countries cannot avoid a debt restructuring could play an important role in reducing the deadweight loss of default.
What about Greece?
The recent experience suggests that the economic costs of default may not be as high as it is commonly thought, and that economic recovery has often started soon after default. It is worth noting, however, that in all defaults studied in our work the economic recovery was helped by an exchange rate depreciation. Since this does not seem to be an option for countries that belong to the Euro area (for reasons that are well explained in Eichengreen, 2007), Greece may pay a steep cost if it were to default. For this reason, we hope that rescue plan launched on May 2nd will work and that Greece will not belong to the sample when we update our paper on the costs of default.
Blustein, Paul. 2005. And the Money Kept Rolling In (and Out): Wall Street, the IMF, and the Bankrupting of Argentina, Public Affairs: New York
Borensztein, Eduardo and Ugo Panizza. 2009. “The Costs of Sovereign Default.” IMF Staff Papers, Vol. 56: 683-741
Borensztein, Eduardo and Ugo Panizza. forthcoming. “Do Sovereign Defaults Hurt Exporters?” Open Economies Review
Bulow Jeremy, and Kenneth Rogoff. 1989. “A Constant Recontracting Model of Sovereign Debt.” Journal of Political Economy, Vol. 97: 155–178.
Cole, Harold and Patrick Kehoe. 1998. “Models of Sovereign Debt: Partial versus General Reputations.” International Economic Review, 39: 55–70.
Eaton, Jonathan, and Mark Gersovitz. 1981. “Debt with Potential Repudiation: Theoretical and Empirical Analysis.” Review of Economic Studies, 48: 289–309.
Eichengreen, Barry. 2007. The euro: love it or leave it? VOX EU, 17 November 2007
Grossman, Herschel and John Van Huyck. 1988. “Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation.” American Economic Review, 78: 1088–1097.
Inter-American Development Bank (2006) Living with Debt. Report on Economic and Social Progress in Latin America
Levy Yeyati, Eduardo and Ugo Panizza. forthcoming. “The Elusive Costs of Sovereign Default.” Journal of Development Economics
Panizza, Ugo, Federico Sturzenegger, and Jeromin Zettelmeyer. 2009. "The Economics and Law of Sovereign Debt and Default." Journal of Economic Literature, 47: 651–98.
Rose, Andrew 2005. "One Reason Countries Pay their Debts: Renegotiation and International Trade.” Journal of Development Economics, 77: 189–206.
This article first appeared on www.VoxEU.org. Reproduced with permission