As governments remain focused on the current health crisis and finding ways to help consumers through what will be a Great Depression-sized quagmire that could leave lasting effects for decades to come, one issue that’s been largely ignored is the threat unserviceable sovereign debt poses to the global economy.
Ever since the Great Recession fostered a new normal of low rates and easy access to credit, there has been a growing concern among economists that a prolonged era of cheap, free flowing capital could one day come back to haunt us. It seems that day is now upon us.
Now for some sovereigns—those with their own currency, own central bank, don’t borrow in foreign currencies, and don’t have a history of fiscal mismanagement or political corruption—today’s crisis doesn’t pose a threat to national solvency or the stability of international financial markets. However, some countries may experience such extreme funding stress from Covid-19 that they are thrust into an impossible dilemma: follow the Washington consensus of invoking austerity measures to restore national solvency—decimating the financial health of millions in the process—or default on all outstanding obligations and start over entirely.
You may think this is a pretty easy decision, but interestingly, in some cases, default can be the better option. Too often we forget that just because a person, company, or government takes on debt, it doesn’t mean they necessarily have to pay it back. There is a reason creditors charge interest on the money they lend: borrowers may not pay all the money back, and charging interest protects the lender’s downside. If repayment was guaranteed, there would be no risk for creditors lending money; in fact, they would lend to any and all who needed cash.
But since this isn’t the world we live in, and since there is always some likelihood of default—regardless of a borrower’s credibility—interest is charged accordingly. Safe borrowers are charged a low rate, risky borrowers are charged a higher rate, and nowhere is this more evident than the market for sovereign debt. Government intervention in markets (QE) can distort this identity, but the logic still applies.
So given the increased likelihood of capital flight and sovereign funding stress due to Covid-19, which countries are at most risk of default, and which ones may in fact choose to default? (Sometimes a country has the ability to continue making payments but decides that doing so is more costly to the electorate. For instance, if servicing national debt takes away from funding vital health programs, who’s to say defaulting isn’t the moral thing to do?)
Let’s look at a couple of examples.
Currently in negotiations to restructure its $65 billion in foreign debt, Argentina is a classic example of a country that would be wise to expunge its debt load. The country is struggling to service its foreign obligations due to the collapse of the peso, and it will likely experience significantly lower tax revenues due to Covid-19. What’s interesting about Argentina, though, is that while the country is known as a serial defaulter—defaulting 8 times by some estimates—rarely has it had issue incentivizing investors following default. This is partly because when a government defaults, it typically offers higher returns on subsequent debt issuances but also because the typical repercussions of default, such as an inability to incentivize foreign investment, and widespread capital flight, have shown to be negligible for Argentina.
Italy is another one. While Italy’s struggles are different in composition than Argentina’s, the country has just as much if not more to gain from default. The country is the world’s 8th largest economy yet is hamstrung monetarily and has zero exchange rate flexibility because of its participation in the Euro. They simply don’t have the tools they need to fix the problems they face. If they chose to default, and leave the Euro entirely, they would have a fresh start—without the policy limitations of a monetary union— and still possess the economic output needed to lure foreign investors.
But how realistic is it that Argentina, Italy, or others in similar scenarios default?
The simple answer is that each case is different. Since the country has a long history of defaults, an Argentinian debt expungement would come as little surprise to investors. Though, it’s also not guaranteed. The IMF could exert its power to ensure continuity of payment, even if doing so is detrimental to the lives of everyday Argentinians. Similarly, Italy could determine that, given today’s economic uncertainty, taking a risk averse approach and remaining in the Euro, with access to cheap European Central Bank cash, is the safest path forward. This notwithstanding, it’s still pretty hard to argue that Italy isn’t being held back by its participation in the Euro.
The truth is there’s no way of determining how any country will react to today’s economic unrest. We are all in uncharted territory. The point, though, is that when deciding how to proceed in an era of declining government revenue and soaring costs, leaders shouldn’t be afraid of asking the very important question: “Why not default?” Sometimes, it may be the most prudent thing to do.