Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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