In the past few weeks I have been getting a lot of questions about serial sovereign defaults and how to predict which countries will or won’t suspend debt payments or otherwise get into trouble.  The most common question is whether or not there is a threshold of debt (measured, say, against total GDP) above which we need to start worrying.

Perhaps because I started my career in 1987 trading defaulted and restructured bank loans during the LDC Crisis, I have spent the last 30 years as a finance history junky, obsessively reading everything I can about the history of financial markets, banking and sovereign debt crises, and international capital flows. My book, The Volatility Machine, published in 2002, examines the past 200 years of international financial crises in order to derive a theory of debt crisis using the work of Hyman Minsky and Charles Kindleberger.

No aspect of history seems to repeat itself quite as regularly as financial history.  The written history of financial crises dates back at least as far back as the reign of Tiberius, when we have very good accounts of Rome’s 33 AD real estate crisis.  No one reading about that particular crisis will find any of it strange or unfamiliar – least of all the 100-million-sesterces interest-free loan the emperor had to provide (without even having read Bagehot) in order to end the panic.

So although I am not smart enough to tell you who will or won’t default (I have my suspicions however), based on my historical reading and experiences, I think there are two statements that I can make with confidence.  First, we have only begun the period of sovereign default.

The major global adjustments haven’t yet taken place and until they do, we won’t have seen the full consequences of the global crisis, although already Monday’s New York Times had an article in which some commentators all but declared the European crisis yesterday’s news.

Just two months ago, Europe’s sovereign debt problems seemed grave enough to imperil the global economic recovery. Now, at least some investors are treating it as the crisis that wasn’t.

The article goes on to quote Jean-Claude Trichet sniffing over the “tendency among some investors and market participants to underestimate Europe’s ability to take bold decisions.”  Of course I’d be more impressed with Trichet’s comments if pretty much the same thing hadn’t been said before nearly every previous crisis.  Before the decade ends, I am pretty convinced, there will be several countries, including European, struggling with the process of debt restructuring, and some of the victims will surprise us.

The second statement I think I can make with some confidence is that there is no threshold debt level that indicates a country is in trouble.  Many things matter when evaluating a country’s creditworthiness.

As a rule anything that increases the chance of a sustained mismatch between earnings and debt servicing undermines the creditworthiness of the borrower.  But what really matters is not the expected outcome so much as the probability of an extreme outcome.  The expected variance, in other words, is more important than the mean expectation, which is another way of saying that a country with less debt and more variance can be a lot riskier than a country with more debt and less variance.

What are the risk factors?

I would argue that there are at least five important factors in determining the likelihood that a country will be suspend or renegotiate certain types of debt:

1. Of course debt levels – perhaps measured as total debt to GDP or external debt to exports – matter.  As a general rule, the more debt you have, the more difficulty you are going to have servicing it.

But we shouldn’t get too caught up in nominal debt levels.  Coupons matter too.  So, for example, as part of the Brady restructuring of the 1990s, most loans were exchanged either for “discount bonds”, which included an explicit amount of debt forgiveness via a reduction in principle, or “par bonds” which included no explicit reduction in principle, but the coupon was reduced.

In fact par bonds and discount bonds implied the same real amount of debt forgiveness, but this debt forgiveness did not show up as a lower nominal debt level in the case of the par bonds.  It showed up as a lower nominal coupon.

This Brady-bond talk may seem largely academic, but it has a very important modern-day implication.  It means that financial repression also matters a lot – even though it gets little attention in discussions about sovereign credit risk.  In some countries, most notably Japan and China, interest rates are set artificially low – much lower than they would be by the market.  Local central banks can do this because the financial systems in these countries are heavily banked (i.e. most savings and financing occur through the banking system), there are few investment alternatives, and the financial authorities determine deposit and lending rates.

Forcing down interest rates in this way has exactly the same effect as the lowered coupons on the “par bonds” described above.  It implies significant (and hidden) debt forgiveness, so when we look at Japanese and Chinese debt-to-GDP ratios we must remember that we should conceptually reduce the nominal debt levels to reflect the fact that the interest coupon is artificially low – perhaps reducing nominal debt by as much as 30-50%.

This is why Japan was able to raise its nominal debt level to what seemed unimaginably high (and why if it is ever forced to raise interest rates to a more reasonable level, it will face real difficulty), and why although I believe China has a debt problem, I do not believe this problem will show up in the form of a banking or sovereign debt crisis (instead it will show up as lower consumption, as I explain in my July 4 post).

2. The structure of the balance sheet matters, and this may be much more important than the actual level of debt. In my book I distinguished between “inverted” debt and hedged debt.  With inverted debt, the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times (when asset prices and earnings rise) and rise in bad times.  With hedged debt, they are negatively correlated.

Foreign currency and short-term borrowings are examples of inverted debt, because the servicing costs decline when confidence and asset prices rise, and rise when confidence and asset prices decline.  This makes the good times better, and the bad times worse.  Long-term fixed-rate local-currency borrowing is an example of hedged debt.  During an inflation or currency crisis, the cost of servicing the debt actually declines in real terms, providing the borrower with some automatic relief, and this relief increases the worse conditions become.

Inverted debt structures leave a country extremely vulnerable to debt crises, while hedged debt helps dissipate external shocks.  Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.  I discuss this a little more below when I talk about virtuous and vicious cycles.

3. The economy’s underlying volatility matters. Less volatile economies can safely bear more debt because their earnings are less subject to violent fluctuations, especially if the performance of the economy is correlated with financing ability.  This is especially a problem for countries whose economies are highly dependent on commodities.  Not only are commodity prices volatile, there is a long history suggesting that global liquidity dries up at the same time that commodity prices collapse.

This is a deadly combination for highly indebted economies with big commodity sectors.  Commodity importers, however, benefit because their volatility is negatively correlated to market conditions (unless of course they have stockpiled commodity prices in a misguided decision to “hedge” themselves – effectively reinforcing inversion in their balance sheet).

It is possible to create a measure that adjusts debt levels according to underlying economic volatility.  The first academic piece I ever published, in 1993 I think, looked at 1975-80 external-debt-to-export ratios for a number of developing countries and found no predictive ability.  In other words if you had used these ratios back then to predict which countries would have defaulted on their external debt in the 1980s and which didn’t, you would have done no better than if you simply tossed a coin.

But when I used an option formula to adjust the ratios to incorporate the volatility of their export earnings, suddenly the predictive ability of the adjusted ratios became extremely good.  The more volatile the country’s export earnings, in other words, the more likely it was to default for any given amount of external debt.

4. The structure of the investor base matters. In my opinion contagion is caused not so much by “fear”, as most people assume, but by large amounts of highly leveraged positions (including leverage through forwards, options, and leveraged notes), which force investors into various forms of “delta hedging” – i.e. buy when prices rise, and sell when they drop.

This kind of trading strategy automatically reinforces price movements both up and down and spreads them across asset classes.  Highly leveraged markets are highly susceptible to contagion, whereas markets with little imbedded leverage almost never are.

5. The composition of the investor base also matters. A sovereign default is always a political decision, and it is easier to default if the creditors have little domestic political power or influence.  Unless foreign investors have old-fashioned gunboats, or a monopoly of new financing, for example, it is generally safer to default on foreigners than on locals.  It is also easier to “default” on households via financial repression than it is to default on wealthy and powerful locals.

One corollary, by the way, is that the total value of assets owned by a government does not matter in determining likelihood of sovereign default as much as many might assume.  Governments are not subject to corporate or bankruptcy law.  In any individual country you will often hear optimists say that in spite of high debt levels the country will not default because the government owns more assets than it has liabilities.

You should ignore this argument.  This is muddled thinking on many counts (for example how easily can you sell assets in a liquidity crisis?), but rather than go into detail, let me just point out that throughout history defaulting governments have almost always had significantly more assets than the value of their liabilities (in fact I cannot think of any exception).

There is usually, however, a significant political cost to relinquishing those assets – that is usually why the government owns them in the first place.  If that cost is greater than the cost of default, the government will default.

Beware virtuous cycles

What does all this tell us about the probability of a country’s being forced into default or restructuring?  Perhaps not much except that tables that rank countries according to their debt ratios are almost useless in measuring the likelihood of default.  This would be true even if those rankings were accurate, but not surprisingly countries hide a lot of their real obligations, and the riskier they are the more likely they are to hide them, so the inaccuracy is always biased in the wrong direction.

It also suggests that investors really need to look very carefully into each country’s underlying economic volatility and, most importantly, the country’s debt structure, since the structure of the balance sheet, and the correlation between asset values and liability values, may actually be more important than the outstanding amount of debt.  Countries with a lot of short-term debt, external debt, and asset-lending-based banks, especially large amounts of real estate lending, are far more vulnerable than they might at first seem because the debt burden is likely to soar at the worst time possible – just when everything else is going wrong.

Lots of hidden and off-balance sheet debt is also a very bright red flag, because these structures nearly always implode just when economic conditions sour.  One of the main points of the IADB’s Living with Debt (2006) is that nominal debt levels just before a crisis often seem reasonable, but suddenly surge because of an unexpected (but easily predictable in retrospect) explosion in contingent liabilities.

In fact some of the recent “star” sovereign performers may very well be the biggest risks, since their great performance may have been caused in part by highly inverted balance sheets.  These kinds of debt structures ensure that good times are magnified, but they also ensure that bad times are exacerbated.

Remember this when someone argues that Country X is doing very well and has even locked itself into a virtuous cycle, in which a good event causes other good events that are self-reinforcing.  There are few things as risky as highly virtuous cycles, which are almost always caused by inverted balance sheets.  Many of my Brazilian friends, for example, wince whenever they hear about virtuous cycles, because they know first hand how virtuous cycles can quickly collapse into vicious cycles.

Until 1997, for example, Brazil’s biggest credit problem was its huge fiscal deficit, more than 100% of which was explained by interest payments on short-term debt.  As global conditions improved during the middle of the decade, Brazil was caught up in a powerful virtuous cycle.  The improving external position caused local interest rates to decline, which dramatically reduced the projected fiscal deficit, and so boosted confidence, causing interest rates to decline even more.

Inverted structures are toxic

It was wonderful – and happening very quickly – with real interest rates dropping from the 30-40% range to the 20-25% range in a matter of two or three years.  But the 1998 crisis set off a devastating reversal of that process.

A global flight to quality caused Brazilian interest rates to rise.  Rising rates dramatically pushed up the government deficit (the financial authorities had not bothered to lock in the low rates, believing that the game would go on until domestic interest rates were at an “acceptable” rate), which caused confidence to drop.  Declining confidence forced interest rates higher, and so on with the result that interest rates spiraled out of control as each event reinforced the other.  Brazil was forced into a currency crisis in January 1999.

It was a similar process for the countries participating in the Asian crisis of 1997.  During the early and mid 1990s it seemed obviously clever to borrow in dollars to fund local operations since dollar interest rates were much lower than local currency rates, and moreover the dollar was depreciating in real terms.  The more locals borrowed dollars and converted into local currency, the more local asset markets boomed and the lower the real cost of the financing (compared to borrowing in local currency).

It seemed like such an easy way to make money, until it stopped.  At some point the risk caused by the massive currency mismatch (a highly inverted structure) became unbearable and the market went into reverse.  Suddenly, and just as local asset markets were collapsing because of capital flight, so did the value of the local currency.

With the collapse of local currency values, all the once-cheap dollar debt went toxic, soaring in relative terms until one company after another faced bankruptcy.  Of course each company made overall conditions worse by trying to hedge its dollar debt – buying dollars simply pushed local currency even lower, and increased the cost of the dollar debt.

The Asian wreck was magnified by another inverted debt structure: asset-based loans in the banking sector.  When the economy is doing well, rising asset prices make existing loans seem less risky and encourage riskier debt structures (i.e. loans whose servicing cannot be covered out of minimum expected cash flows) because creditworthiness seems constantly to rise.

But once the crunch comes, asset values and creditworthiness chase each other in a downward spiral.  The fact that this has happened a million times before, most spectacularly in Japan in the 1980s, never seemed to affect anyone’s evaluation of the risks.

The extent of the carnage in Asia shocked everyone, but it shouldn’t have.  We were lulled into overconfidence precisely because balance sheets were so inverted, and made good times so much better, but the very fact of the inversion determined the speed and violence of the balance sheet contraction.

So who is at risk?

If investors want to know, then, which countries are vulnerable, they should look not just at overall debt levels, but also at the relationship between liability and asset values and the ways in which leverage among investors tie different markets together.  They must determine, in other words, the extent to which when things go bad they all go bad at once.

And they shouldn’t forget to consider how the political pain will be distributed.  If you were a policymaker in some southern or eastern European country, for example, would you be more worried about very high levels of domestic unemployment persisting for several years, or about the risk of causing deep damage to German or French banks?

No hate mail, please, I am just asking, but I did notice an article in Monday’s Financial Times which reports that a number of senior officials from very large European banks are terribly worried that “the stress test exercise of 91 banks will produce a skewed league table of institutions based on misinformed comparisons of financial strength.”

The banks in question are generally recognised to be among those that will pass the test.  “It is not a question of whether we will pass,” said one finance director. “It is that the market will compare our stressed capital ratio with others that have been calculated in an entirely different but untransparent way.”

It’s not that I don’t sympathize – when people dislike me I, too, worry that they’ve simply been misinformed.  My European friends in the know, however, seem more worried that the “stress” conditions, about which we are given next to no information, are not nearly stressful enough, and may not sufficiently distinguish between good sovereign holdings and bad ones.  I guess we’ll know Friday.  The FT article reports however that “even some regulators admit in private that the process has been chaotic and could backfire.”

Now there’s a confidence booster.

43 Responses to “Do sovereign debt ratios matter?”

  1. [...] This post was mentioned on Twitter by Ella Chou, George Hutchings. George Hutchings said: China Financial Markets » Do sovereign debt ratios matter? [...]

  2. on 20 Jul 2010 at 4:56 amSergei

    Well, there is only one economic factor driving sovereign default – monetary sovereignty. The rest is just neoliberal make-up. As soon as we realize it and move to inflation problem the better the solution to all our economic problems will be.

  3. on 20 Jul 2010 at 5:38 amLinks 7/20/10 « naked capitalism

    [...] Do sovereign debt ratios matter? Michael Pettis [...]

  4. on 20 Jul 2010 at 6:06 ammarks

    Would appreciate your comments on this GaveKal article. Does this analysis jive with your views on China (i.e. growth in Chinese wages and increased Chinese domestic household purchases).


  5. on 20 Jul 2010 at 6:15 amMartin Walker

    A very useful note, but what happens in the case of UK, where government debt is mainly long-term (about 12-13 years, I think) but banking debt is more short-term?

  6. on 20 Jul 2010 at 7:30 amDefunktOne

    Awesome summary! Thank you for the post. Too many people look at basic sign posts and conclude everything good as gold. However, on the ground and in the governments of sovereigns, the details are far from pristine.

    I for one, think China is a Russian default in the waiting. When essentially the entire market projects a country to reign supreme for the next 50-100 years, it’s worth taking a much deeper look.

    Thanks again!

  7. on 20 Jul 2010 at 8:54 amDiego Méndez

    Interesting article. But why are you so cryptic about who’s going to fail?

    If you analyze the “underlying economy” / exports, Portugal and Greece don’t seem well positioned, since their trade is not so intertwined to Europe as Spain or Italy.

    I mean, Spain manufactures 4m cars yearly. Most of them are exported. If they can increase that figure some 25% to 5m through wage deflation and other competitivity measures (cheaper freight transport), it can easily close the trade-deficit gap. That’s not something Portugal or Greece can do.

    Anyway, I can’t agree with this dilemma: “If you were a policymaker in some southern or eastern European country, for example, would you be more worried about very high levels of domestic unemployment persisting for several years, or about the risk of causing deep damage to German or French banks?”

    The real dilemma is not unemployment now or German banks. The real dilemma is unemployment now or getting out of the euro, which means facing Third-World financial conditions in the short, medium and long term, hence more poverty in the future.

    Moreover, the political cost of forced banking holidays (corralito) and savings destruction through devaluation is probably much higher than that of unemployment.

  8. on 20 Jul 2010 at 10:03 amOGT

    “Beware the Virtuous Cycle” sounds like a book title to me. Brilliant Post! Some of the stuff seems like common sense for any lender, the quality of earnings matter as much as quantity. But I have never seen this written about sovereign debt!

    Also the financial repression piece doesn’t seem well understood. I would love to see an estimate of the fiscal balance and overall tax rate calculated for China and Japan if the implied ‘tax’ of interest rate repression was factored in.

  9. on 20 Jul 2010 at 11:09 amDean Jackson

    Some observations.
    You note at the onset commentators say the European crisis is almost over and conclude “I guess we’ll know Friday” regarding the stress tests. Whether it is Europe or the U.S., much of the political class, Wall Street, and the press has been glossing over issues for well over a year. Accentuate the positive second derivative when the first derivative is negative; then vice versa. Expect no less in the wake of Friday’s announcement.
    Second, you note Japan dealt with their problems partially by suppressing rates to sustain high levels of nominal debt. That game may be coming to an end because of the demographics. Within in the past week I read the Postal Savings is set to make the final transition from being a large net buyer of bonds over the past decades to being a net seller. That is symbolic of the larger problems.
    Third, when I read your list of warning signs, I cannot help but think of the U.S. Lots of short term debt; check. Lots of asset based lending is the foundation of the economy in recent decades; check. While it is dollar denominated, lots of externally held debt; check. Contingent debt; check. While commentaries generally focus on publically held debt still being less than 60%, the treasury debt held by the government trust funds and the very real implied guarantee of the agency debt at this juncture would already elevate the true obligation to more than 110% of GDP. When I read statements that then say we could just inflate our way out, I laugh because almost 50% of the debt is either in the form of inflation adjusted payment streams (TIPS) or so short term that inflation would not provide the relief it did in the decades after WWII.
    I think you are right and I would look well beyond certain obvious European countries.

  10. on 20 Jul 2010 at 11:59 amvv111y

    Hi Michael,
    Since you mention Minsky, have you looked into Steven Keen?
    book – ‘Debunking Economics – the naked Emperor of the social sciences’

    thanks again for the posts.

  11. on 20 Jul 2010 at 12:18 pmAnonymous Jones

    Just another fantastic post. Reminded me of how much I liked your book (easily my favorite of the genre). Your analysis is far more complex than that of almost all the other analysts out there, but you write in such clear fashion and organize in such a logical way, that it all seems almost simple. I have been writing much lately about cognitive limitations, and the seeming insistence of so many to focus solely on the simple debt-ratios without investigating the obvious complicating factors that you list is very frustrating. Educated, intelligent “experts” should do better. Anyway, not that it matters, well done…

  12. on 20 Jul 2010 at 1:15 pmbena gyerek

    so how about we put together a complete list of possible vulnerabilities?
    – fx mismatch
    – duration mismatch
    – term structure / refinancing risk
    – collateral valuation
    – investor leverage
    – income / gdp correlation
    – ….?
    would be interesting to do a complete list, then a grid against different major economies.
    one other thing to think about – most emerging markets are small compared to the rest of the world, so you can take a ceteris paribus approach. but with the usa, germany or japan, the impact on the rest of the world is massive. hence for example we get the perverse outcome that a financial crisis in the usa leads to strengthening of the dollar because of a generalised flight to quality. so a simple extrapolation from em experience may not be appropriate.

  13. on 20 Jul 2010 at 6:01 pmDH

    For what it’s worth, I commented -politely- negatively on your article on the Greek crisis. Since, I’ve more or less changed my view based on your work, that is, putting no longer the blame on Greek shoulders alone, but (also) on those of the exporting northern countries. There’s remarkably little a free market can do about the (forced) inflow of capital and its corrosive effects.

  14. on 20 Jul 2010 at 8:25 pmMike G

    M. Pettis:

    As some others here, I noticed that you danced around the question of who are more at risk.

    The concepts you introduced made sense, but their application by those who haven’t used them before may miss some big issues that you assume are obvious. While you have respect in the blogosphere, I don’t think that it is of such weight that your giving us your analysis using the criteria you put forth is likely to cause raids by the bond vigilantes :)

    Please give us some some of your “suspicions” and the reasoning behind them.

    As always, your article was very thought provoking.

  15. on 20 Jul 2010 at 11:02 pmFT Alphaville » Further reading

    [...] “There is no threshold debt level that indicates a country is in [...]

  16. on 20 Jul 2010 at 11:16 pmDan Wilson

    So which countries will make a list?
    US has the gunboats, and can debase the dollar further if needed, so it will never default.

  17. on 20 Jul 2010 at 11:29 pmjohn haskell

    Thank you for another excellent piece. Ever since I read Yves Smith’s airy dismissal of the 1998 Russian default as “purely opportunistic” I have been waiting for someone to put out a framework explaining why it happened. I guess that a debt load of 12.5% of GDP is not that great. But debt costs of 12.5% of GDP per annum (your point 1, “coupons also matter”) can be a problem. Too bad Yves missed that one.

  18. on 20 Jul 2010 at 11:55 pmSimon

    Thank you for another great post. I especially like this one because it outlines new concepts to mull over and try to internalize. I really enjoy these macro economic discussions because they are both complex and simple at the same time. The concepts are difficult to absorb but once that processing is done they can be applied simply and provide powerful understanding of the world we live in. Thanks again.

  19. on 21 Jul 2010 at 12:26 amFurther reading | beyondbrics |

    [...] Michael Pettis – Do sovereign debt ratios matter? [...]

  20. on 21 Jul 2010 at 3:15 amRien Huizer

    Good post. Maybe now more people undertsand that predicting national deaults is multi-dimensional.
    Good to focus attention on economic volatity as a variable to include in observations. Problem is of course that this is a backward looking one. But it leads to an approach that is analogous with modern approaches to look at the riskyness of corporate debt.

    This is of course a vast subject and as we have seen recently, a combination of “savings potential” (as in Greece -people familiar with the peculiarities of Greece will agree that a determined gvt can extract a lot more than has been done until recently without damaging the sources of income for the national economy) and plausible access to support (the EU) can improve a hopeless situaltion. Maybe not cure it completely, but that is asking too much. Relief should last long enough to make an adjustment to soemthing that is more in line with earnings potemntial (under EU/EUR rules) , the people’s capacity to endure pain and the gvts capacity to inflict pain withoiut losing power.

    An entirely different aspect of “gvt debt” is of course contingent liabilities. Many states (especially the US state governments) have direct or indirect (as the US in the case of the states) very l;arge contingent liabilities. Some of these are highly definable, like unfunded pension liabilities, others much more contingent, like the liabilities of the private financial system that may migrate to the gvt balance sheet under conditions of severe systemic distress, with or without a formal obligation on the part opf the gvt to support the financial system in this way.

    It is a complicated problem and one thing is certain: rating agencies are even less equipped to predict gvt default than they were to judge most CDOs….There is simply no complete theory that can be applied. And the paralel with corporate debt is wrong: investors in corporate debt have far more opportunities to diversify away the risk that ratings and outcomes vary too much. Which basically means that regulated investors (banks, life insurance comp[anies etc) should not be allowed to rely on ratings when investing in country debt not denominated in a currency the government can print (state or quasi state). One good reason to create a single (monopolistic) issuer of EUR denominated gvt debt, that would be guaranteed by all EUR participants and onlend to the various state governments on the basis of pre-agreed budget deficits. That entity should of course also have priority over all other claims on those member states… Everyone should like this, no?

  21. [...] “Do sovereign debt ratios matter?“, Michael Pettis (Prof Finance, Peking U), 20 July 2010 [...]

  22. on 21 Jul 2010 at 9:52 amGaryP

    Thought provoking as always.
    Not certain, but I think Prof. Pettis is, quite politely and obliquely, pointing the finger at the US as a country at risk. Perhaps not, it may be me reading into the article something not intended.
    Also, if China and Japan are (covertly) taxing their citizens by keeping interest rates so low, isn’t the US doing the same thing. Vanguard has closed their large money market fund holding US Treasury debt (because of demand or because they can’t cover expenses of the fund buying short duration Treasury debt). Today it is paying 0.01% interest! Will investors eventually rebel and insist on some return or will they continue to trust the US Govt to be so safe they are willing to (almost) pay them to take their money? I think that this situation could change rapidly and could overwhelm the govt’s ability to control it.
    Hope not, for selfish reasons, but we probably should consider the possibility.

  23. on 21 Jul 2010 at 4:50 pmKimo

    Thanks for the excellent thoughts. I wonder if China really does have control over interest rates….

    “Bankrupt Chinese Manufactures Lend to Real Estate Developers at Shark Loan Rates”

  24. on 22 Jul 2010 at 6:01 amAaron

    Michael: I think you made a mistake in the first paragraph of “Risk Factor #2″ (“The structure of the balance sheet matters…..”).

    Your correlations are backwards. It should read “With inverted debt, the value of liablities is NEGATIVELY correlated…” etc. And the end of the paragraph should read “With hedged debt, they are POSITIVELY correlated.”

  25. on 22 Jul 2010 at 6:16 amJim Baird

    All of the Eurozone countries are at least potentially at risk, becuase they are currency users who actually have to get their money from taxes or borrowing to spend it. Japan, the UK, and the US are not at risk at all, no matter what their debt ratio, since they are currency issuers. Currency issuers do not “borrow” their own money of issue, in any real sense, so they cannot defualt unless they decide not to pay their bills.

    Until you understand this basic financial fact, you are doomed to talk nonsense.

    Jim Baird

  26. on 22 Jul 2010 at 6:42 amAaron

    Re: Jim…

    Read your own comment….. “so they cannot default unless they decide not to pay their bills.”

    In which case, they… default.

    Just because a country has the option of printing vs defaulting it does not have to choose printing. It can choose to default or renegotiate, or it can choose to print. You guys always make printing sound like the “no-brainer.” As Michael points out, default is a political decision. There are circumstances where default or renegotiation is actually easier politically than printing. Currency issuers can and do default.

  27. on 22 Jul 2010 at 8:39 amcurt

    A very important issue to think about in regards to sov default is who holds the financial asset – that is who is the lender. Next, ask yourself, “do the holders of the financial assets have significant power of the government, directly or indirectly?” It is not just a case of the financial asset holders being foreign or not, what matters is if they have the power to make the government do their bidding; that is to be able to stop the government from attempting to destroy their financial assets.
    In many cases the holders of the financial assets are local, concentrated in number, and politically very powerful. These are the types of cases where there will be no default, debt restructuring, nor inflation. The power elite will use their strength in gvmt to force gvmt to sell real assets to satisfy the financial asset claims. In others cases, the holders of the financial assets are foreign, concentrated in number, and very politically powerful. The same results from this group..sometimes called gunboat diplomacy.
    For a default to happen, the creditors should mostly be foreign and lacking of political power. The use of inflation happens primarily when the creditors are local and are lacking in political power.

  28. on 22 Jul 2010 at 10:17 am(no link) warren mosler

    seems you make no distinction between the guy with money in his pocket who refused to pay and the guy with no money in his pocket.

    or between the bowling alley that can refuse to give you your score and the guy with no money who can’t pay you.

    The difference is between being operationally constrained or not operationally constrained.

    The Fed is not operationally constrained and spends by changing numbers on it’s spread sheet the same way the bowling alley posts your score.

    Greece and CT are operationally constrained by the balance in their transactions accounts.

  29. on 23 Jul 2010 at 4:54 amsimple financial analysis

    Do sovereign debt ratios matter?…

    I have been trying to find an objective and easy to understand answer to this question and this is truly impressive… I’m always impressed with the truly analytical economic analysis by Michael Pettis and make it required weekly reading……

  30. on 23 Jul 2010 at 10:22 amAshutosh

    Is USA doing financial HARAKIRI?

  31. on 23 Jul 2010 at 11:52 amKe

    Warren, you make it sound like the Fed is free to do whatever it wants without feeling pressure from foreign debt holders and domestic taxpayers.

  32. [...] Do sovereign debt ratios matter? Do sovereign debt ratios matter? [...]

  33. on 25 Jul 2010 at 12:35 pmJohn K

    Floating fiat currency issuers never default. Why would they? None have ever found it more convenient politically to default than print. And the 800 pound gorilla, the US, put non-default in the US constitution. This was tested in the courts – and the Supreme Court said “… the government is not at liberty to alter or repudiate its obligations.”

  34. on 25 Jul 2010 at 6:16 pmJudy Yeo

    Mr Pettis

    Interesting and timely piece. Amid all the talk that seems aimed at “talking the markets into some state of positive stability”, it’s nice to ahev some sobering moments. Just perhaps some points that raised the brow a little.

    Mr Pettis:contagion is caused not so much by “fear”, as most people assume, but by large amounts of highly leveraged positions

    True, technically, the positions are what cause the irreversible damage and spiral effect. However, often you’ll find that the trigger is realisation that the crap has hit the fan and the fear that ensues. It’s not hard to get that creepy feeling when you’re in the midst of a group of traders who have just experienced that phenomenon, you can smell the fear that comes on the heels of that realisation.

    The point about the stress test was quite to the point, was rather amused by the reactions over the past week. Are they, aren’t they? Privately, suspect many are not quite convinced by these PR efforts any more.

    The inverted debt structures and the magnifying effect they have (negative and positive) is intriguing, for the lack of a better word used to describe it as a multiplier effect, great to have the “correct” nomer for it! May be the next roundof crisis will throw up even more insight, have my suspicions that we are not that far from things going badly really quickly, all it really takes is realisation in some quarters.

  35. on 26 Jul 2010 at 1:52 amRien Huizer

    Re “currency issuers and currency users”: would people worried about the robustness of banks owning lots or EUR denominated EUR country sovereign debt (and these countries cannot “issue” EUR, at least not like the US can issue USD) please take a look at who owns USD denominated US state and municipal debt, especially in the light of very large unfunded pension liabilities in places like California (California is no more able to print its own money than Greece) and be at least equally worried?

  36. on 26 Jul 2010 at 11:36 pmJoe Citizen

    A little voice in my head is screaming Australia and Canada at me when I read the phrase “sovereign stars”. Anyone else?

  37. [...] assertivo. Há uma declaração que ele afiança “fazer com total confiança” ao escrever “Do Sovereign Debt Ratios Matter?” [um artigo que merece ser lido na íntegra]. “Só agora começámos o período de defaults na [...]

  38. on 27 Jul 2010 at 6:15 pmCoyote des savanes

    This is not exactly about balance sheets, but rather to point to a recently poublished paper in (28 July): TITLE – Just how risky are China’s housing markets?
    by Yongheng Deng, Joseph Gyourko, Jing Wu
    URL –

    Perhaps your somewhat cryptic reference to sovereign defaults that might surprise us makes me think that a realestate blowout in China would be bad not only for China.

  39. on 27 Jul 2010 at 8:37 pmJudy Yeo


    No one is disputing the precariousness of certain states (in the USA) in terms of state (vs federal) finance, the differences lie in the sovereignty issue and the question of how much control (american states vs european nations) there is over financing tools. Arguably, European nations are a lot more sensitive (paranoid)when it comes to sovereignty issues whatever the implications of the union might be. For all practical purposes, it is just a union, not a single unified country. That technically means opting out is always an option, something that’s gonna make country A a lot less willing to follow the dictates of B or C when the going gets tough and D being even less willing to be mired in the mess of A when its own citizens are fuming.

    Great to see you actively blogging again :)

  40. on 28 Jul 2010 at 12:28 pmVladimir

    Great post as always, Professor.

    But, as a Brazilian myself, let me make a few remarks about the 1998/99 currency crises. First of all, I don´t think that the Brazilian government could have “locked in” lower rates during the boom. Even though conditions were better than usual before the crisis, the yield curve was extremely steeped due to a number of factors (history of high inflation, high volatility of IR, serial defaults, you mame it). It was not like they could finance the debt by issue long term fixed rate bonds but decided to just keep things unchanged. They couldn´t.
    Another point is that, IMHO, the crisis was caused more by the FX linked domestic debt than by skyrrocketing short term IR rates. And the lesson that the Brazilian government took from that experience was much more one of the dangers of having this kind of debt (and of having a fixed FX rate regime when you are unwilling or unable to keep the FX rate undervalued) than of the prociclical nature of short term debt.

  41. [...] discussed some of these issues in my July blog entry.  Interestingly enough, today Reuters reported what many believe is a major new initiative in [...]

  42. [...] discussed some of these issues in my July blog entry.  Interestingly enough, today Reuters reported what many believe is a major new initiative in [...]

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