Sovereign debt default risk (or the absence thereof)

A recent empirical paper by Paulo Mauro and Jing Zhou suggests that even if r – g < 0, that the interest cost of government debt is less than the growth rate of the economy, then the risk of sovereign debt default may still be of concern for advanced economies:

“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 below: sharp, sudden movements in marginal borrowing costs – not the average interest rate, r – typically precede sovereign debt default episodes and result in greater debt refinancing challenges for governments.

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 heterogeneous, country-specific conditions such as the currency denomination of debt, ownership of debt and debt maturity structures, 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 sterling-denominated and relies on a very large, liquid and stable domestic market whereby also the Bank of England is able to intervene and 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 depend heavily on external borrowing in foreign currencies and cannot rely upon a domestic, independent central bank to cure its liquidity and solvency woes. Additionally, the UK’s long-dated sovereign debt has a weighted average maturity of approximately 14 years, more than twice than that of the US and the OECD average. The implication is thus that the UK’s fiscal space is, to a relatively large extent, insensitive to and insured against sharp jumps in marginal interest costs in the short to medium term, unlike most of its peers.

This is important to understand because I suspect, just as it were the case a decade ago following the previous global downturn, the present economic crisis will likely renew interest in fiscal austerity among opportunistic and ignorant policymakers who, similar to a decade ago, will likely perpetuate fear-mongering rhetoric concerning the possibility of the UK experiencing a Greece-style sovereign debt crisis. Though, I hope that I’m wrong.

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