by Calculated Risk on 7/10/2010 08:30:00 AM

CR Note: This is part 2 in a series on sovereign debt issues by reader "some investor guy". Here is Part 1: How Large is the Outstanding Value of Sovereign Bonds?

Sovereign bonds have been defaulting for almost as long as there have been sovereign bonds. The problems go back many centuries. A good overview created for the IMF is “The Costs of Sovereign Default” by Eduardo Borensztein and Ugo Panizza. Some countries are “serial defaulters”, with a long history of sovereign defaults. Many have defaulted on sovereign debt five times or more.

Click on graph for larger image in new window.

Here is a chart showing the number of countries defaulting each year from 1824 to 2003. The raw data comes from S&P. Charts were created by the Some Investor Guy.

As you can see, there are some years with no defaults at all, and other years with many. Defaults tend to come in clusters, and the behavior of lenders often changes substantially after defaults. In the Volatility Machine, Michael Pettis asserts that sovereign default contagion follows predictable patterns, and that contagion is primarily due to investors in the first defaulting country also having investments in other countries which are vulnerable. This is especially the case with leveraged investors.

In the seemingly “quiet period” from 1945 to 1959, there was just one sovereign default. Interestingly, this was also a time with a number of very angry foreign investors. This time period was the peak of expropriation of foreign assets. There were at least 25 nationalizations and expropriations of foreign assets. Many were by new members of the Soviet Bloc, and by newly independent colonies (Source: Michael Tomz, Stanford, working paper).

For you ubernerds who want to see which countries defaulted each year, here they are. I’ve broken them down into three periods to make the charts more readable.

1820 to 1920(click on chart for larger image)

1920 to 1980

1981 to 2003

The underlying causes of default (such as rises in interest rates, wars, commodity price collapses, and simply borrowing too much money) have been diagnosed for many episodes. Proximate to the default, any of the following six financial changes might occur:

1. Government revenues fall far below history or forecast;
2. Expenses aside from debt service rise far above history or forecast;
3. Interest rates rise substantially; due to inflation, credit spreads, illiquidity, or other causes
4. Demand for bonds suddenly drops or disappears (a sudden stop);
5. Exchange rates move, making payments on foreign denominated bonds much more expensive (currency risk), and,
6. A government simply decides not to pay, even though it has the capacity to pay (repudiation).

Paolo Manasse and Nouriel Roubini studied sovereign default risk and concluded that many guidelines used for estimating when default was likely did not perform well, primarily because those guidelines looked at separate risks. For example, total government debt exceeding 200% of GDP is often used to indicate stress. However, some other circumstances may make the problems much less severe (like having a growing economy and no foreign denominated debt). Other factors might make it much worse (like high inflation).

CR Note: This is from "Some investor guy". Over the next week or so, some investor guy will address several questions: What are market estimates of the probabilities of default? What are total estimated losses on sovereign bonds due to default? What happens if things go really badly and what are the indirect effects of default?

Next in the series, Part 3. What are the Market Estimates of the Probabilities of Default?

Series:
• Part 1: How Large is the Outstanding Value of Sovereign Bonds?

• Part 2. How Often Have Sovereign Countries Defaulted in the Past?

• Part 2B: More on Historic Sovereign Default Research

• Part 3. What are the Market Estimates of the Probabilities of Default?

• Part 4. What are Total Estimated Losses on Sovereign Bonds Due to Default?

• Part 5A. What Happens If Things Go Really Badly? $15 Trillion of Sovereign Debt in Default

• Part 5B. Part 5B. What Happens If Things Go Really Badly? More Things Can Go Badly: Credit Default Swaps, Interest Swaps and Options, Foreign Exchange

• Part 5C. Some Policy Options, Good and Bad

• Part 5D. European Banks, What if Things Go Really Badly?