IN DECEMBER 2001 Argentina defaulted on $81.8 billion of sovereign debt, after months of turmoil in the country’s banking system. That led to the abandonment of its exchange-rate regime and a sharp devaluation of the peso. Argentina’s GDP plummeted by 10.9% that year. It has been locked out of international capital markets ever since.
In Greece such tales now have a worrying resonance. Despite raising $6.7 billion on bond markets on March 29th, the scale of the country’s financing needs means that an eventual default cannot be ruled out. Both Greece’s 2009 budget deficit, at 12.7% of GDP, and its debt-to-GDP ratio of 113.4% are higher than the corresponding figures for any sovereign defaulter between 1998 and 2001.
If the worst were to happen, how much pain might it suffer as a result?
In theory, default should be costly. The damage it causes is the main incentive for debtor countries to honour their promises. Yet there are clearly lots of occasions when governments judge that the benefits of defaulting outweigh the costs. An IMF study by Eduardo Borensztein and Ugo Panizza counts as many as 257 sovereign defaults between 1824 and 2004. Between 1981 and 1990 alone, there were 74 defaults (see chart).
In fact, the evidence suggests that the penalties for default are often less severe than those meted out to Argentina. Its experience of being shunned by international capital markets is not typical, for example. At least in recent years defaulters have been able to re-enter markets once debt restructuring is complete. Argentina’s woes stem partly from the fact that it is only now, more than eight years since it defaulted, nearing a final deal with its creditors (see article).
Defaulting does affect the cost of funds to a country. A study in 2006 by a trio of economists at the Bank of England found that countries which defaulted between 1970 and 2000 had both a higher bond spread and a lower credit rating in 2003-05 than countries with the same debt-to-GDP ratio which did not default. In their study Messrs Borensztein and Panizza show that having defaulted is associated with a credit-rating downgrade of nearly two notches.
Using data for 1972-2000, they also find sizeable jumps in bond spreads after a default. In the first year spreads widen on average by four percentage points. This additional cost declines to 2.5 percentage points the year after. These figures may understate the pain, however: as the Greek case shows, worries about default are enough in themselves to lead to an extended period of high spreads.
That said, markets appear to have short memories. Only the most recent defaults matter and the effects on spreads are short-lived. Messrs Borensztein and Panizza find that credit ratings between 1999 and 2002 were affected only by defaults since 1995. They find that defaults have no significant effect on bond spreads after the second year.
This tallies with earlier research by Barry Eichengreen and Richard Portes. Studying bonds issued in the 1920s, they also found that recent defaults resulted in higher spreads but more distant ones had no effect.
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