Are We Facing a New Wave of Sovereign Bond Defaults?

Carmen Reinhart and Ken Rogoff have a very peculiar op-ed in the WSJ today, warning of the risk that there will be another wave of emerging-market sovereign bond defaults. Now Rogoff, a former director of the IMF's research department, is the kind of person who tends to know what he's talking about. So let's just say I'm puzzled by his attitude here, and would love him to clear up a couple of things.

Reinhart and Rogoff are certainly provocative: "Already, a good share of Argentina's debt is in default," they write, and they're not talking about untendered pre-restructuring debt:

What else do you call it when a government that owes over $30 billion in inflation-indexed debt manipulates its consumer-price statistics? Through a variety of crude measures (such as firing its top statisticians), the government is publishing an understated inflation rate that is used for calculating indexation payments.

Well, I, for one, don't call it default, I call it manipulation of consumer-price statistics. Someone buying inflation-indexed debt runs both default risk and statistics-manipulation risk; the latter is not a subset of the former. There's a big debate raging in the US about whether and how the US CPI might understate "actual" inflation, however that might be defined, but no one is suggesting that if CPI is understated then TIPS are somehow in default. And default is a state of affairs, not a state of mind: you can't say that Argentina is in default just because it is deliberately manipulating its statistics.

But the idea that CPI fudging is a form of default seems to be key to the rest of Reinhart and Rogoff's argument:

Governments do not usually cheat holders of only one type of debt. In April, we published a National Bureau of Economic Research paper based on centuries of debt data from many countries. We found that most countries default on external debt only a bit less freely than on domestic debt.

So my first question is: Does the April paper consider fudged inflation statistics in the presence of index-linked debt to be the same thing as a default? Somehow I doubt it, I can't see how it would be possible to come up with a rigorous metric of inflation fudging.

I can quite readily believe that outright default on domestic debt is a good indicator that the country in question is likely to default on external debt as well. But I'm not convinced that the same is true of inflation-fudging, which, at the margin, is more of a means of avoiding a default on domestic debt.

Reinhart and Rogoff then make a huge leap from Argentina, with its fudged inflation statistics, to any country with high inflation:

Considering the duress of domestic bond holders across the world as global inflation rises, it is surprising that both private investors and multilateral international financial institutions seem so complacent about the rising risks of defaults on external debts.

I really don't understand what this means. Yes, inflation is a good way of reducing a government's real debt burden, especially if a lot of that burden is in the form of bonds carrying a nominal interest rate. Insofar as inflation is higher than investors expected when they first bought the debt, domestic investors especially will get a lower real return than they had hoped for. But again, this is inflation risk, not default risk. Indeed, my intuition is very much that inflation can be used to "inflate away" nominal debts and thereby avoid default. I really don't understand the logic here; how does rising global inflation mean a rising risk of default on external debt?

But maybe it's not rising inflation that Reinhart and Rogoff are worried about, so much as rising domestic debt:

There have been many episodes in the past where rising levels of domestic debt have sharply raised risks to external debt holders. There is nothing new about the rise of domestic debt markets. They are simply growing again after a bout of suppression during the high-inflation 1980s and 1990s.

Well, are levels of domestic debt rising? In real terms? I understand that not all emerging-market countries are commodities powerhouses with massive balance-of-payments surpluses which have already achieved net creditor status (Brazil). But I also haven't seen much evidence that levels of emerging-market sovereign domestic debt are rising particularly quickly. Still, Reinhart and Rogoff do have one example of the kind of thing they're talking about:

When India effectively defaulted on its domestic debt through massive inflation and financial repression in the early 1970s, external debt holdings suffered payment reschedulings even though they constituted only a tiny fraction of overall debt.

So we're back to Argentina, it would seem - we're not worried about "global inflation" rising a point or two, but rather about countries with "massive inflation" - inflation so massive, indeed, that it constitutes an effective default.

If Reinhart and Rogoff were making a narrow argument - that Argentina's inflation constitutes an effective default on its domestic debt, and that having defaulted on domestic debt the country is unlikely to have a lot of qualms about defaulting on its external debt - then I wouldn't really have a problem with the op-ed. I'm not sure I'd buy the argument completely, but at least it would make a certain amount of internal sense. And with Argentina's external debt trading at 570bp over Treasuries, there is indeed quite a lot of default risk priced in already.

But Reinhart and Rogoff seem rather to be making a much broader argument, that inflation globally is a warning sign that emerging-market sovereign debt generally could be facing a new wave of defaults. And the case for that seems to me to be much weaker.

Comments

[huangjin:]

I read their paper and it is worth checking out. You can view it here:
www.publicpolicy.umd.e...

The title of their paper should give you some indication of their thesis: This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.

What does it matter to the investor if a country recognizes it cannot pay its debt and defaults, versus a country that refuses to default and prints its way out? The underlying economic factors are the same and will lead to financial crisis. And yes, consumer credit is growing in Brazil.

"Like private-sector banks in Brazil, Banco do Brasil has benefited from increasing demand for consumer credit, which has been expanding at a steady pace as the economy grows and as domestic interest rates remain near historic lows.

Banco do Brasil's credit portfolio surged 23.1 percent in the first quarter from a year earlier, reaching 172.76 billion reais. In 2008, it expects its loan portfolio to expand 25 percent."
www.reuters.com/articl...

Also see this:
"The shortest distance between a U.S. shopper and the product he or she craves: credit, preferably of the card variety.

For many Latin American consumers hoping to get their hands on a personal computer, the barrier is the same — or more precisely, it's the lack of credit.

"Really, nobody but a couple companies will finance consumers," said Peter Weigandt, head of Dell Inc.'s business in Latin America.

Dell and other computer makers are developing novel ways to tap into the rapid growth in Latin America and other emerging markets. In Mexico, Dell and Telmex launched a program five years ago that allows consumers to buy a PC, then pay for it in installments on their monthly phone bills. Because Telmex controls nearly all the phone lines in Mexico, Weigandt says, the program has had a very low default rate.

Those and similar programs are key for Dell, Hewlett-Packard Co. and other major computer makers as they look to offset slowing growth in mature markets with the boom in several developing countries."
www.statesman.com/busi...

2008 Jun 24 03:03 PM

[Reinko:]

The author asks himself the following question, quote:

Well, are levels of domestic debt rising? In real terms?

Unquote.

Comment: See this detail from the FED Z1 release, look in the first column and scroll down, link:

www.federalreserve.gov...

Lets look at non financial debt only:

2007 Q4:31249.3
2008 Q1:31758.4 billions of US$.

So in one quarter has this part of the US picked up over 500 billion more debt, for the year this will mean about 2000 billion or 2 trillion.

That is a size of about 15% of the yearly gross domestic product in more debt and this is only a segment of US society.

Conclusion: Debt growth is still a multiple of gross domestic product growth. The law of exponentials still says the biggest exponent wins and thus total debt will grow on and on...

As a comparison:
Suppose company 'Blink it Blue' has a market cap of 100 million and every 2 to 3 years they sell bonds in 100 million US$ bundels.
Would you invest in the long run in that company?

2008 Jun 24 03:28 PM

[Chris White:]

Thank you for these thoughts. The preservation of value is an interesting question. It might be interesting to compare the U.S. present circumstance with other Third World precedents. Would not the application of the medicine the US and international institutions insisted was necessary to restructure third world debtors be an option for the US's international lenders now? It might be, for example, that the current US situation could usefully be compared with Mexico in 1982 from the standpoint of capital flight, currency over-valuation, endebtedness. The ratios of values in Mexico before and after the devaluation and restructuring of 1982 might provide a better indicator of what's ahead than comparisons with the stag-flation of the 1970's when the US economy was very different than it is now.

2008 Jun 24 03:56 PM

[domsam:]

_And default is a state of affairs, not a state of mind: you can't say that Argentina is in default just because it is deliberately manipulating its statistics._

If the manipulation is real, the bondholder in effect is being paid a lower coupon rate. than the contractual coupon rate.
In essence there is a restructuring of the bond which I think is a default. And it is the state of affairs.

2008 Jun 24 06:11 PM

[buyitcheap:]

Wait until the entities with VRDOs hit their standby facilities... goodbye banks...

2008 Jun 24 06:59 PM

[dedalo:]

I personally hold Argentine inflation index bonds and, although I am aware of the inflation numbers being manipulated, it all comes down to how much the bonds are yielding, and at the current ultra discount prices, these bonds are returning over 20%, even when the official inflation is around 10%. What is being priced here is the (totally unrealistic) risk of default. Argentina is indeed, like Brazil, a commodities powerhouse. Unlike what happened in the 90s, when commodities where low, the country is now benefiting massively from the current commodities supercycle (which will not end any time soon), and has had a trade surplus for the last six years, export dollars flooding the country, and its currency getting stronger (in the last month it´s gained 5% against the dollar). Anyhow, thanks to delirious articles like the one on the WSJ and all the default-paranoia, it is now possible to buy these bonds at such a discount and get a great yield, plus the currency valuation.

2008 Jun 24 07:27 PM

[mangy cat:]

adding to dedalo
and also as a holder of indexed argies of almost all durations -well almost all from pr11 at barely 1.1 yrs duration to parp at 15 yrs, and even cuap indirectly at my afjp account-
look at the extreme convexity of the yield curve

what the market seems to say is:
pick up 14 % ytm now on most traded 2.5/5 duration segment (pre9, nf18) and break even with "official" 9/10% cpi now, to recoup with hefty gains later when indec returns to normal

otherwise instead of ytm on longer bonds dropping to 10%
"realist" default expectations would push the yield curve parabolical

where i do agree with rogoff quoted is on:
"governments do not usually cheat holders of only one type of debt"
as proven by like treatment for globals and (domestic) bontes in 2002
the paradox is the approx 10% pricing gap between otherwise identical domestic and foreign usd bonds (para/pary; dica/dicy; tvpa/tvpy)
but that may be reflecting fear of exchange rate controls (differential payback) rather than of default

2008 Jun 24 09:00 PM

[bearfund:]

Makes no difference what you call it; default, devaluation, manipulation. The bottom line is that the investor gets less than he should. Governments are comprised of humans and therefore have human foibles. Humans will with very few exceptions always succumb to the temptation to steal if they know they will not be punished for it. And inflation-indexed bonds are nothing more than the honour system writ large. I'd never dream of buying an indexed sovereign bond; it's already practically impossible to get anything out of a defaulted sovereign obligation, devaluation is always a risk, and when you add in manipulation that's three strikes. If a sovereign wanted to allow an independent international entity to measure its inflation and index to that, I might think about it. But in truth all sovereign debt is underpriced because the risk of default and devaluation are always much higher than the market assumes. I'd much rather buy well-secured senior debt of major corporations; if they default, I get an interest in something tangible that has real value. Strangely, they yield more, too. If a sovereign defaults, devalues, or manipulates, I get the shaft. I don't like getting the shaft. Just say no to sovereign debt.

2008 Jun 25 12:00 AM