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Sovereign default
Sovereign default

Hat tip FT Alphaville

In October 2009 Michael Hudson and Steve keen gave a talk in Melbourne in which I first heard the term “debt jubilee”. Basically harping back to ancient times, when on the order of the king, all debts were periodically forgiven.  It seemed whacky. Still does. Not that I was not unaware of the problem. In preference to the first US TARP I advocated for the Market Ticker Guy’s suggestion of wiping out shareholders and converting bond holders into shareholders, allowing the now debt free company to issue new bonds. If the company still could not survive, it would enter bankruptcy.

I still believe this would have been a far superior approach to TARP 1. While we can not undo what has been done, we can make sure it does not happen again. Those who bore the risks, expected and for many years received the gain should have felt the pain. Not the ordinary citizens. The people have a lot of hard times ahead of them.

But in a fit of madness, or under the excessive influence of the financial sector governments around the world have taken on the debt. Even high flying Australia has guaranteed debt equal to 100% of GDP. There is too much debt. It will not be repaid in currency worth anything like as much as it is now. That is a near certainty. Whether debt is defaulted on, renegotiated down or paid back in debased currency depends on what happens. That it is not paid in full value is inevitable.

The nature of globalization and linkages means that tsunamis of default will at some point role around the world. The magnitude of exposure at over two trillion is enough to wipe out many banks:

Hat tip Black Swan Insights

The relative exposures become clear in a chart Black Swan Insights knocked up from the BIS report::

The inevitable sovereign defaults will be resisted. They will still eventuate. If the ‘default’ results from anything other than inflation, it will cause a liquidity crisis on top of the solvency crisis. This will wreck merry hell. It will also be eerily similar to the Great Depression:

“The immediate effect of Central Europe’s collapse was the terrible unsettlement of all economically sensitive nations everywhere. Among the dire consequences were Britain’s suspension of payments to foreigners, abandonment of the gold standard by scores of nations, trade wars, political revolutions in more than a dozen countries outside of Europe, and disaster for the American economy.

The eventual effect of this gigantic catastrophe was to kindle political and social revolutions in all the defeated nations of Central and Eastern Europe. Communism reached its dread hand into those areas, and Fascist dictators arose as the antidote. In the end, these forces were to plunge the world into a Second World War”.

Source: here or for the complete volume here (large file).

Herbert Hoover also points out in his autobiography:

“For an outraged people may destroy the whole economic system rather than reconstruct and control the segment which has failed in its function.” (Kindle location 628).

As the costs of the bailouts and to be honest, the credit induced boom which preceded them become apparent, there will be much outrage. Demagogues will try and advance themselves. It will be a difficult time for democracy in much of the developed or indebted world.

Many countries will soon be facing opinions similar to those being published in Ireland:

Flowing from this conclusion comes the view that a portion of that debt must be defaulted on. The most obvious and frequently mentioned portion of that debt that advocates of default point to are monies lent to Irish banks, including senior bonds.

There are very powerful arguments to support the default view, and the strongest argument against it, from Ireland’s perspective, evaporated last week – that argument was that any default on bank bonds would cause lenders to stop giving money to the Government to fund its deficit. That has now happened anyway.

It is no longer in Ireland’s narrow national interest to prevent senior bondholders from suffering the consequences of their own bad judgement.

It is inevitable that some will succumb and default. Even if not of their own volition, they will be forced to. Not every country has its debt denominated in its own currency. Furthermore, I suspect many of the banks will have liabilities denominated in foreign currencies. If the institutions are nationalized, then the State takes on their debt and will lose the ability to use inflation to reduce the value of the debt.

Norman Strong has produced a primer for nations on how to default.

Next, prepare the default. You don’t want to take your creditors by surprise; give them three days notice. Call the IMF team – in town only a week, and not feeling fully in control – and your advisors to a 6 AM meeting. Tell them that at noon, you plan to announce a payment moratorium starting in three days. Wave aside their objections, tell them that the decision is made, and ask them to assemble a creditors’ committee.

After the default is announced, huddle with the IMF team and help them to draft their press release. It ought to state that the IMF team is in the country, and that the government is working with them. This is as close as you will ever get to an “IMF-sanctioned default,” and is basically taken as such by the markets. If the IMF plays rough, play the nice guy and intimate you will sign a rigorous program. Now is not the time to play hard ball, and the program agreed matters less than you might think, given that these things are made to be renegotiated

Your starting point should be an exchange of all your outstanding bonds for new bonds worth 50% of face value. This is an aggressive stance, but your creditors will respect that. You hold the cards. The IMF will extend credit for the reconstruction of your economy only after you have come to an agreement with the majority of your creditors. Pay the army and reduce interest rates as much as you can; you can now return to the budget you wanted to pass with a greatly reduced external payments line. Don’t hurry to remove controls on capital outflows.

After a decent interval, say eighteen months, time will be ripe for you to “return to the market”. You will pay a bit more on your debt, but not prohibitively much, and quite possibly this premium will be outweighed by the improved outlook for your economy. (Thailand, which has never defaulted, pays more for its money than many Latin American sovereigns which have defaulted repeatedly.) The market has surprisingly little memory, and any residual uneasiness will be easily assuaged by an additional quarter-point of yield. You may now declare the crisis over.

If countries were more like companies, nobody would ever suggest that a risky and volatile proposition which looked like the typical emerging market economy should be funded out of debt; it would be funded out of venture capital or equity. Stockholders do well in good times, but share in the pain of bad; debt is a much more unforgiving arrangement, since principal and interest are fixed and regularly due. Since countries can’t float stock (not yet, at least), they can do the next best thing, which is issue debt on which one plans to default if things get tough. Markets rarely figure this out in advance, and they have short memories.

While not the focus of the primer, it does contain political signals for investors to look for that might indicate impending default. Although Michael Pettis has identified more obvious signals:

Its official – Spain and Portugal will need to be bailed out soon.  How do I know? In one of my favorite TV shows, Yes Minister, the all-knowing civil servant Sir Humphrey explains to cabinet minister Jim Hacker that you can never be certain that something will happen until the government denies it.

So check out this article in Tuesday’s Financial Times:

Spanish and Portuguese leaders, with reinforcements from Brussels, are fighting a rearguard action to convince investors that there is no need for further eurozone bail-outs after the €80bn-€90bn ($109bn-$122bn) rescue agreed for Ireland at the weekend.

“Absolutely not,” said Elena Salgado, Spanish finance minister, when asked in a radio interview on Monday whether Spain needed help from the European Union. “Spain is doing everything it has promised to do, with tangible results.”

Portugal is regarded by bond market investors and economists as next in line for a rescue after the bail-outs of Greece and Ireland. But José Sócrates, Portuguese prime minister, was adamant that there was “no connection” between the Irish rescue and Portugal’s problems.  “Portugal doesn’t need anyone’s help and will solve its own problems,” he said, insisting that the country had a clear strategy to cut its yawning budget deficit.

Was Sir Humphrey exaggerating?  Perhaps, but I do remember that Dublin was pretty adamant just a week or so ago that there would be no restructuring of Irish debt.

On the Euro and the merits of defaulting Michael Pettis concludes:

Several countries, most notably Spain, will be forced to choose between giving up sovereignty to Germany, suffering extremely high rates of unemployment for several years, or giving up the euro.  They will almost certainly choose the third option.  There are still a lot of people who say giving up the euro is “unimaginable”, but that just shows a weak imagination. I especially remember in 2000 Domingo Cavallo dismissing the stupidity of foreign investors who imagined Argentina might be forced to suspend payments and devalue the peso – which it did in late 2001.  More recently, on April 30, Cavallo warned Greece: “Don’t even think of abandoning the euro, whether temporarily or definitively, because that will provoke a financial catastrophe in Greece and various other countries in Europe.”  Now there’s some useful advice, especially when you consider the huge surge in growth and the fall in unemployment Argentina experienced after it devalued.

It seems we have some countries that will be desperate to avoid other countries defaulting. Germany and the UK will be particularly keen in keeping the European peripheral countries paying. It might be a ponzi scheme, but with inflation it is one they hope they can survive.

However the people of the PIGS may be better off if they default. Bailouts are not really about the affected banks. It is about who they owe money to. It is the foreign banks that foreign countries are worried about. Why taxpayers should take on massive debts to bailout foreign bond and shareholders is beyond me. It will no doubt be beyond many of them.

Of course, history is replete with leaders betraying their people for personal gain. In a democracy they will not last long. But the European Union is not a democracy. One has to wonder how the European Union riot police are coming along.

But realistically, there are too many countries with too many arms which would be better off defaulting for EU forces to step in successfully. The European Union is too lacking in legitimacy to overrule them peacefully. The do not have the forces to override the desires of its composite states. In any event, the merest hint of civil war would probably initiate the credit event they are trying to avoid.

Given the magnitudes of the debt and the likely domino effect of chain defaults the world will be rocked by the financial system. This time it will occur when governments have much weaker balance sheets, thanks to their choice to intervene in the way in which they did.

Essentially the last round of government interventions achieved nothing except more time. This was bought at the cost of a considerable increasing of public debt as they bailed out private debt holders. The decline in sovereign balance sheets limits their ability to meet any future expected event.

They also gave the appearance which may reflect the reality of being captured by vested interests related to their financial system. It is hard to see how their behavior differed to that of a kleptocracy.

Yves has more on this subject  here and here.

UPDATE

Things are moving as expected:

A SUBSTANTIAL majority of the Irish people wants the State to default on debts to bondholders in the country’s stricken banks, according to a Sunday Independent/Quantum Research poll.

The finding that 57 per cent favour and 43 per cent oppose default reflects a growing view among policymakers and opinion formers that the State simply cannot support the debt burden it has taken on.