Sovereign Default Risk

Please take a look at this fine analysis by Michael Pettis. It cuts through the nonsense about the almighty debt-to-GDP ratio that dominates current discussion. This ratio has no predictive power over sovereign default risk; much more depends on the composition of the debt, the volatility of the public revenue stream, and the forces acting upon creditors. Above all, there are moderately procyclical debt burdens (weak economy, weak burden) and monstrously countercyclical debt burdens. You want to assume the first and flee in terror from the second.

Pettis also points toward an interesting political economic aspect of the fundamental asymmetry between surplus and deficit countries. He writes:

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.

While credit markets may be segmented, being a deficit country increases the likelihood that sovereign debt will be held by foreigners. We often think of deficit countries as being weaker or more vulnerable, and they are, but governments often fear their domestic elites more than the global lords of finance.