Since the lost decade of the 1980s a rich literature on financial crises has evolved, including a theoretical literature which emphasised the potential for self-fulfilling expectations within a zone of vulnerability (e.g. Krugman 1996). The empirical counterpart of this literature focused on the probability of crisis given fundamentals, but did not try to delineate the zone of vulnerability, or the complementary safety zone.
Our contribution to that literature was to focus on the border of the safety zone for sovereign debt. In particular we investigated conditions under which default on external and domestic sovereign debt never happened in low and middle income countries from 1974-2001 (see Van Rijckeghem and Weder 2009, which builds on the methodology of Osband and Van Rijckeghem 2000).
Defaults on external debt were defined based on Standard & Poor’s classifications while defaults on domestic debt were defined based on Standard & Poor’s or a large increase in credit to the government. Near-defaults which were only avoided through external assistance were not considered as defaults. We considered democracies and non-democracies separately. We found that default never occurred in parliamentary democracies with broad money nine times smaller than foreign-exchange reserves or in democracies with less short-term debt than reserves and with growth over 3.4%, for example. For domestic debt, no democracies entered into default with inflation below 7%.
These results did not mean that debt crises would never be observed under these configurations in the future, but did indicate that if a default were to occur under these configurations, it would be a very unusual event. In fact, it was possible to calculate the probability of a default occurring under these or better fundamentals using simple non-parametric statistics. With 39 external debt defaults between 1974 and 2001, the 40th external default had a 2.5% chance of occurring at fundamentals better than those in the past.
Implications for the Eurozone
Today, we find that the paper results have several implications for the Eurozone. Most importantly, they point to the importance of growth. As is well known, growth is critical for avoiding default through its impact on both the size of the deficit and the scaling variable in the debt-to-GDP ratio. The empirical counterpart already noted above is that no default on external sovereign debt was ever observed in a democracy with growth over 3.4% provided there was sufficient balance-of-payment liquidity support. The implication for the Eurozone is that to restore safety, higher growth needs to be actively pursued.
Growth also helps prevent political polarisation, and here another result is revealing. Default on external debt did not happen in any democracy in periods of low international interest rates (specifically a US treasury bill rate of less than 5%) when there were sufficient political constraints (as measure by Henisz’ Polcon index)1. Sufficient representation of interests against default (those depending on trade who might face sanctions, those owning government debt or bank stocks which would suffer in case of default, etc.) has ensured that. Growing discontent as the result of austerity may be the most important factor yet in influencing the probability of default.
At the same time, our research shows that in democracies budget deficits smaller than 4.4% are sufficient historically to avoid default on external sovereign debt at times when international liquidity is plentiful. The latter condition is fulfilled in today’s world. But the former is not. In fact many developed economies have current deficits well above 4.4%. In particular the UK, US, and Japan have deficits above 8% and among periphery countries in the Eurozone Greece and Ireland and Spain are above 7%.
Based on this criterion, these countries are in a zone of vulnerability. It will take time for these countries to carry through the fiscal consolidations programs that can bring them into the safety zone.
Is the Eurozone more vulnerable?
There are limitations to what we can learn from the past, if the world has changed or the Eurozone is special. The Eurozone is special because individual countries cannot count on the central bank acting as lender of last resort to the sovereign2. This makes self-fulfilling crises possible, since high spreads (say because of an expectation of Eurozone breakup) make sovereign defaults more likely. This may explain why Italy, which according to past experience should be safe – with a deficit of about 2%, primary surplus of 4% – yet is under attack (even if this is not the same as default, which is what we measure in our study). The ECB bond buying together with the European Stability Mechansim conditionality aim at addressing these issues, and are therefore an element of 'getting in the safety zone'.
Also, contagion in a currency union is stronger because of the possibility of redenomination risk, which in turn is affected by actions of all the members of the club. Since uncertainty has spread and even breakup is being priced in, spreads of most countries in the Eurozone periphery are now 'made in Europe'. In other words, the decisions taken in Athens, Berlin and Frankfurt count more than those of the own government3. Therefore the conditions for safety critically depend on conditions that were not included in our study since they are less important for countries not in currency unions; namely the political ability of other debtor countries to reform or the willingness of creditors countries to finance adjustment programs4. This suggests that the safety zone may be smaller for countries within a common currency area.
A factor which goes in the other direction is that in our research sample of developing countries and emerging markets contained countries with 'serial defaults', which as a result built up 'debt intolerance'. Countries which have not lost their reputation can tolerate higher debt, e.g. the US is considered a safe asset despite public debt of around 100%, and Japan’s public debt has reached 270%.
In conclusion, the scorecard of many Eurozone countries indicates that they need to build a higher safety buffer of good fundamentals – in terms of growth and deficits to ensure safety from default. One way to do this is to shield countries from high spreads resulting from expectations of Eurozone breakup, while providing time to restructure and consolidate, so as to not kill growth.
In principle ECB bond buying plus the European Stability Mechanism could achieve this. However, the solution suggested by the German Council of Economic Experts, the European Debt Redemption Pact, has the advantage that it represents a transparent and credible long-term commitment device. It aims at reducing debt slowly to 60% over 20 years, thereby protecting growth and requires collateral, earmarking of revenues and European control. In turn, the joint and several guarantee for all participants for interim debts over 60%, signals a long-term political and economic commitment from the stronger Eurozone countries to maintaining the integrity of the Eurozone. Together, this would constitute a grand bargain, addressing high spreads and reducing the needed primary balance to reach the 60% target and get out of the danger zone.
German Council of Economic Experts, Bofinger, Peter, Lars P Feld, Wolfgang Franz, Christoph M Schmidt, and Beatrice Weder di Mauro (2011), “A European Redemption Pact”, VoxEU.org. 9 November.
Krugman, Paul (1996), “Are Currency Crises Self-Fulfilling?”, NBER Macroeconomics Annual 1996, Volume 11
Osband, Kent and Caroline Van Rijckeghem, “Safety from Currency Crashes,” International Monetary Fund Staff Papers, V.47, No.2 (December 2000).
Pisani-Ferry, Jean, “The Euro Crisis and the New Impossible Trinity”, Breugel Policy Contribution, Issue 2012/01, (January 2012).
Van Rijckeghem, Caroline and Beatrice Weder, “Political Institutions and Debt Crises,” Public Choice, V. 138, No. 3-4 (March 2009).
1 The POLCON index is higher when the executive power faces more veto points and when preferences are not aligned across different branches of government.
2 There is now a “new impossible trinity” of strict no-monetary financing, no co-responsibility for public debt, and bank-sovereign interdependence, as highlighted by Pisani-Ferry (2012).
3 See IMF Spillover Report 2012, Figure 5 for evidence that spreads in most countries of the Eurozone Periphery are explained mainly by events that are not related to the country itself.
4 The parallel for the countries in our sample is dependence on IMF and Paris Club decisions to grant support, so there is some element of uncertainty related to decision makers outside the country in our sample, but to a lesser extent.