Fiscal Policy

UK Sovereign Debt Default Risk (or the absence thereof)

A recent empirical paper by Paulo Mauro and Jing Zhou suggests that even when r – g < 0 (i.e. the interest cost of government debt is less than the growth rate of the economy), the risk of sovereign debt default may still be of concern for both advanced economies and emerging markets:

“Sovereign default histories demonstrate that after prolonged periods of low differentials, marginal rates can rise suddenly and sharply, shutting countries out of financial markets at short notice.”

Their claims are sufficiently grounded in observable evidence, as depicted in the following charts: sharp, sudden increases in marginal borrowing costs have typically preceded (recent) sovereign debt default episodes.

However, whilst most nations may be susceptible to sovereign debt crises (as we might soon observe again, i.e. Argentina), it would be disingenuous to suggest that this risk could equally apply to Britain.

Indeed, long-run public debt sustainability isn’t just driven by interest-growth dynamics; it also depends on country-specific conditions such as the currency denomination of debt, ownership of debt and debt maturity structure, for example.

With application to the UK, sovereign default risks are, to put it plainly, irrelevant because the government (through the Debt Management Office) is a monopoly supplier of risk-free treasury securities whose long-dated debt is denominated in its own issuing currency and depend on a very large, stable and liquid domestic market whereby the Bank of England can purchase any quantity of gilts if or whenever need be. Thus, the UK does not face the risk of a liquidity crisis turning into a solvency crisis. The same cannot be said for most other advanced economies and emerging markets that rely heavily on external borrowing in foreign currencies and cannot count on a domestic, independent central bank to cure its liquidity and solvency woes.

This is important to understand because I suspect – just as it were the case a decade ago following the previous global downturn – the economic crisis initiated by the COVID-19 epidemic will likely renew interest in fiscal austerity among politicians and journalists who – similar to a decade ago – will likely perpetuate fear-mongering rhetoric concerning the possibility of a Greece-style sovereign debt crises. I hope that I’m wrong.

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