Economic Effects of Sovereign Default Significant but Short
With Iceland skirting with a sovereign debt default, the International Monetary Fund has published a timely working paper that finds that the economic consequences of such a default may be significant but last no more than a couple of years.
The paper, The Costs of Sovereign Default by Eduardo Borensztein and Ugo Panizza, does not represent the IMF’s official view. It evaluates empirically four types of cost that may result from an international sovereign default: reputational costs, international trade exclusion costs, costs to the domestic economy through the financial system, and political costs to the authorities. It finds that the economic costs are generally significant but short-lived, and sometimes do not operate through conventional channels.
The political consequences of a debt crisis, by contrast, seem to be particularly dire for incumbent governments and finance ministers, broadly in line with what happens in currency crises.
Key Conclusions:
- Reputation of sovereign borrowers that fall in default, as measured by credit ratings and spreads, is tainted but only for a short time.
- While there is some evidence that international trade and trade credit are negatively affected by espisodes of default, we could not trace it to the volume of trade credit, as the default literature suggests.
- Debt defaults seem to cause banking crises, and not vice versa, but we found weak evidence to suggest the presence of default-driven credit crunches in domestic markets.
- Finally, defaults seem to shorten the life expectancy of governments and officials in charge of the economy in a significant way.
- On the positive side, we found a fairly sensible estimate of the effect on credit ratings and bond spreads, and we call attention to the sharp increase in government turnovers following debt crises.
- On the negative side, our result regarding how international trade credit affect the link between trade and default and our finding that default episodes do not seem to affect bank lending do not seem to be very plausible.
Perhaps the most robust and striking finding is that the effect of defaults is short lived, as we almost never can detect effects beyond one or two years.
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