Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Sun, 30 Nov 2008

Sovereign defaults

According to data from Markit regarding the five year credit default swap (CDS) market on November 27, 2008, the cost of insuring against default by the US government was 0.5% per annum and the cost of insuring against a UK government default was almost 1%. The CDS market is now attaching a slightly higher probability to a default by the US than by Japan. Germany is seen as significantly less risky than any of these countries.

For comparison, 0.5% is the kind of premium that one might normally pay to insure a decent building against fire. But one must keep in mind that the CDS premium measures the risk neutral probability of default which could be several times the real world probability while for fire insurance, the risk neutral and real world probabilities are much closer to each other.

The sharp rise in the US CDS premium from the single digit levels prevailing before the crisis has left some people wondering whether all this makes any sense at all. Can a government default on debt in its own currency when it can print unlimited amounts of that currency? Above all, how can any entity provide protection against default by the government itself?

These same questions arose and were adequately answered years ago when the major ratings agencies downgraded Japan at a time when it was the largest creditor nation on earth running a large current account surplus. I therefore find it strange that the same questions are arising again now when the creditworthiness of the US is being doubted.

This time, the rating agencies dare not express doubts about the creditworthiness of the US since these agencies are themselves in the dock for the silly ratings that they gave to mortgage securities. It is obviously not a good idea for the rating agencies to antagonize the government that holds the regulatory sword of Damocles over them. The doubts are instead being expressed by impersonal markets in the form of CDS spreads.

So, let us once again remind ourselves that governments can and do default on debt denominated in their own currency. Creditworthiness is not only about ability to pay, but also about willingness to pay. It is reasonable to assume that governments have the ability to pay by printing currency though occasionally a government (Zimbabwe for example) has run out of ink and paper to print notes. The principal problem is about willingness to pay.

The Russian default of 1998 on its ruble debt is a good place to begin understanding the issue. I like to imagine the Russian government being forced to choose between paying its soldiers and paying its creditors. Obviously, it chooses to pay its soldiers – if it makes the wrong choice, it does not survive to tell the tale. Unlike creditors, soldiers cannot be paid in worthless paper. They have to be paid in something that can buy food and other essentials.

The government must therefore print notes on a scale that produces the maximum seigniorage revenues to the government. There is a very simple formula which states that in real terms seigniorage revenues are equal to the stock of real money times the rate of growth of nominal money. If it prints money on so large a scale as to create hyper inflation, then the stock of real money declines (and ultimately collapses to zero) and the government cannot earn any seigniorage revenues regardless of how fast it grows the nominal money supply by printing money.

A point is therefore reached where a government concerned about seigniorage revenues decides to default rather than print more notes. Stating the issue in terms of soldiers versus creditors dramatizes the issue, but we can as well think of it in terms of voters versus creditors and the analysis would be the same.

When one looks at the matter in historical perspective, the idea of government debt being risk free is a twentieth century illusion that is of as little relevance in the twenty first century as it was in the nineteenth century.

Let me now turn to the second question. Is it reasonable to assume that anybody can actually insure against default by the US government? I think the answer is yes provided one takes care not to take out insurance on the Titanic from somebody who is on board the Titanic itself. If one is paranoid, one might want the CDS contract to be governed by say English law rather than New York law and to pay out in say Euros rather than dollars. One might also like the counterparty to be outside the US or at least to have substantial assets outside the US. If these elementary precautions are taken, the CDS can indeed do the intended job as well for defaults by the US government as for defaults by any other reference entity.

Posted at 17:16 on Sun, 30 Nov 2008     3 comments     permanent link


Sharat wrote on Tue, 02 Dec 2008 12:03

Re: Sovereign defaults

Great read Professor.

Gaurav Jain wrote on Tue, 02 Dec 2008 14:51

Re: Sovereign defaults

Sir, CDS spread is going up but 10-yr yield is going down and dollar is going up? Isn't one of these three inconsistent - CDS spread widening, 10-yr yield going down, and dollar strengthening?

Once we include political risk, US is the best place to put money. US current account deficit is narrowing rapidly as its recession intensifies. So one can argue for dollar appreciation. As long as dollar is strong, I don't see how US defaults. Because then it can run a giant Ponzi scheme - take money from new people and pay off the old, or even simpler - just print money. Anyone buying CDS on US should simply short dollar or buy gold outside the US. I am sure currency depreciation will precede any credit event. No worries about being on Titanic.

sharat wrote on Thu, 04 Dec 2008 18:43

Re: Sovereign defaults

I think you have missed the point, He is not suggesting the US will default, only that CDS markets are assigning increased probability of the event and that rating agency refuse to do the same or downgrade US Sovereign Debt when they were quite happy to do it with Japan and its Yen denominated sovereign debt for a variety of reasons which he details. Japan did not default either. Russia defaulted on its domestic currency debt, so it is possible he says.

He then makes a valid point that if you bought a CDS on US Sovereign debt and the payout is either in dollar or the counterparty is based in America, then it doesn't have a lot of meaning in the event of a default.

Its postulating and that's why it so interesting to me, ultimately that kind of default would be catastrophic period whatever currency the payout may be, which ever country your counterparty is located. I think we would all have bigger problems than the price of flour.

A dollar revaluation, a reduction in current account deficits after persistent ones for close to three decades and a reduction in yields as investors flee to perceived quality and the federal reserve cuts rates simultaneously doesn't say very much about default probability, only that people are skittish. Its monkey see monkey do right now. At the beginning of October people were lending money to the Fed and paying them for the honour of holding it. What people believe and what is real are two different things sometimes especially when there is panic.

I don't think a US default is going to happen any time soon either. If it did, expect regime change in China, over night. In fact what is more likely is that the Chinese don't hit that 7 per cent growth they need to keep everyone who is disgruntled from land grabs and unemployment in the minority or swept under the rug. If they don't hit it and it causes political instability and then in all likelihood violent regime change, there would be hell to pay for everyone.