A big sovereign debt default isn’t as likely as you think, the staff of the International Monetary Fund said.
Investors and commentators seem to view a default by a rich-country government as “inevitable,” the IMF said in a paper released Wednesday. Thus the surging debt spreads in places like Greece, Spain, Ireland and Portugal.
But a look at history says the bond market often overreacts to signs of stress – and is likely doing so now, the IMF staff argues in a paper called “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely.”
“Considering data on sovereign bond spreads over the past decades, markets sounded false alarms in the vast majority of episodes,” writes a group of IMF researchers led by the group’s fiscal affairs director, Carlo Cottarelli. “In our view, the risk of debt restructuring is currently significantly overestimated.”
What’s more, Cottarelli & Co. contend, investors betting on a sovereign default are overlooking two important factors: the nature of the fiscal challenges facing big deficit-spending governments, and the generally low borrowing costs available now.
Countries that defaulted over the past 35 years typically did so because they weren’t able to shoulder the high interest payments demanded by a risk-conscious bond market, the IMF said. By defaulting, those governments stood to sharply improve their finances.
By contrast, the governments in the 10 advanced economies under IMF study — France, Greece, Ireland, Italy, Japan, Netherlands, Portugal, Spain, United Kingdom and United States – confront quite a different challenge.
Their budgets are typically in what’s known as primary deficit, a condition in which government spending exceeds receipts — and is expected to do so for the foreseeable future, thanks to rising health care costs and declining demographics.
What these governments need most of all is access to debt markets to cover this persistent, if hopefully narrowing, spending gap. And, as it happens, funds for this purpose are available now at near record-low rates, thanks to questions about the global economic outlook.
Taken together, those factors give governments a strong incentive to take care of their fiscal problems by raising taxes, cutting spending and curbing entitlements, rather than by defaulting, the IMF said.
“In today’s advanced economies, the main issue is the primary deficit rather than the interest bill,” the IMF said. “The needed adjustment … would not be much affected by debt restructuring, even with a sizable haircut.”
This is not to say that the fiscal problems in these countries is something other than dire. The median primary deficit amounts to 7.4% of gross domestic product, the IMF said, which is a high level even without considering the sobering observation that practically all the developed nations are trying to tighten their belts at the same time.
But that’s not to say it can’t be done, the IMF stresses. It says there have been 40 instances over the past three decades, a third of them in advanced economies, in which a country has improved its structural primary budget balance by 7 percentage points or more.
“Judging from past experience, such a major adjustment will no doubt be difficult, but is possible,” the IMF said.
