Bond spreads, along with their close cousin credit default swaps, are a beautifully linear measure of sovereign default risk. They go up in a straight and steady line: the higher the number, the riskier the country is perceived to be. And so they're normally the first and last place that people look when they're interested in the chances of any given country defaulting.
But of course the world isn't quite as simple as that, and - as we have learned the hard way - it's the unexpected defaults which are the most damaging. So I asked Ben Walsh to put together this chart for me, showing a different measure of risk. It's not a better measure, by any means. Still, it's an interesting measure all the same, and it's almost entirely uncorrelated with credit spreads.
The red bars, in this chart, are the credit spreads we're all familiar with. Countries like France, the UK, Canada, and Germany are considered effectively risk-free, while Spain and South Africa and Italy are riskier, India's worse, Greece is very bad, and Argentina is truly dreadful.
And then there's the blue bars, which are related to the concept of a "sudden stop": when all the windows close, and a country simply can't borrow money any more. Such things can arrive with astonishing speed: the markets, in general, will only lend if they think that everybody else is willing to lend. So it's easy for them to shut down very quickly indeed.
The blue bars are also related to the fact that sovereign creditworthiness, at least as the markets understand it these days, is not really a measure of a country's ability to pay off its debts in a timely fashion. Japan is a highly creditworthy country, but it also has public debt of a quadrillion yen. Which, it is safe to say, it will not be able to pay off at any point in the foreseeable future.
In order to be considered creditworthy, even to the point of being considered risk-free, all you need to be able to do is roll over your debts, as they come due. There's something scarily self-fulfilling about this state of affairs: if it's all one big confidence game, then the minute that a country for whatever reason becomes unable to continue to borrow money, then catastrophe is imminent. And, as we saw during the debt-ceiling debacle, there are a lot of reasons why a country might become unable to continue to borrow money.
In a forthcoming paper, Lee Buchheit, the Cleary Gottlieb partner and godfather of sovereign debt restructuring, writes this:
No purchaser of a sovereign debt instrument today does so in the hope and expectation that when the debt matures the borrower will have the money to repay it. The purchaser does so in the hope and expectation that when the instrument matures the borrower will be able to borrow the money from somebody else in order to repay it. This is a crucial distinction. If by sovereign creditworthiness we mean that a sovereign is expected to be able to generate enough revenue from taxes or other sources to repay its debts as they fall due, then most countries are utterly insolvent…
We have allowed a financial system to develop for sovereigns that assumes a more or less perpetual state of benignity - in the debtor country, in the region, in the global economic and political environment and even in the natural world. A disturbance in any of these areas, if it frightens investors sufficiently, risks interrupting the expectation of refinancing that defines sovereign creditworthiness. Many sovereign borrowers would last only a few months, some only a few weeks, if shut off from the ability to refinance their maturing debts. Denied continued market access, they would burn through their reserves with frightening speed.
This is the idea behind the "hang time" measure in the chart above. What we did was to take a country's primary deficit - the amount it needs to borrow every year to finance its operations - and add on its total annual debt service. We then took that number and divided it into the country's total foreign reserves, to get an idea for the length of time that sovereign reserves would be able to fund not only operations, but also all of the country's debt service requirements.
The results are quite startling. Some countries do extremely well on this measure: Russia, for instance has a primary surplus which is higher than its annual debt service, so it could quite happily continue to service its debt in perpetuity, even in the event of a sudden stop. And Argentina looks very healthy on this measure as well: it has a hang time of 280 weeks, or well over five years. Germany and Brazil would both last about three years; even Portugal would last more than a year. But the UK would run out of money in six months, the US would go bust in 17 weeks, and France has just nine weeks' worth of reserves. Japan would have only about 14 days.
Of course, countries like Japan and the UK borrow overwhelmingly in their own currencies, and can always, if push comes to shove, print more of it. The US is in the same boat - and, to boot, has the exorbitant privilege of printing the world's reserve currency. Where fiscal solutions fail, monetary solutions are likely to look attractive. But the chart does show how incredibly fiscally precarious many of the world's safest credits really are.