Blog Post

Sovereign Defaults in Europe

What’s at stake: Dubai’s repudiation of its implicit guarantee on Dubai’s World has prompted a reassessment of sovereign risks around the world and  especially in Europe where there has long been an assumption that the European Union would, if necessary, come to the rescue if one of its periphery country. Simon Johnson says that the […]

By: Date: December 6, 2009 Topic: Global economy and trade

What’s at stake: Dubai’s repudiation of its implicit guarantee on Dubai’s World has prompted a reassessment of sovereign risks around the world and  especially in Europe where there has long been an assumption that the European Union would, if necessary, come to the rescue if one of its periphery country.

Simon Johnson says that the thinking that a partial bailout for Dubai from Abu Dhabi implies something about how Ireland (or Greece) will be treated within the European Union makes sense for three reasons. If Dubai can effectively default or reschedule its debts without disrupting the global economy, then others can do the same. If Abu Dhabi takes a tough line and doesn’t destabilise markets, others (e.g. the EU) will be tempted to do the same as the “no more unconditional bailouts” mantra is appealing in many capitals. And if the US supports some creditor losses for Dubai, this makes it easier to impose losses on creditors elsewhere (even perhaps where IMF programs are in place, such as Eastern Europe).

Willem Buiter says that the massive build-up of sovereign debt as a result of the financial crisis and especially as a result of the severe contraction that followed the crisis makes it all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default, perhaps dressed up as sovereign debt restructuring or even debt deferral. He is pessimistic in that regard about countries characterised by deep polarisation and political gridlock. But if Dubai’s World troubles open our eyes to the likely imminence of the start of the final leg of the journey from household default through bank default to sovereign default, it may actually do some systemic good, by alerting fiscal policy makers to the vulnerability of their nations’ fiscal-financial positions, and by educating citizens and voters to the urgency of deep fiscal burden sharing.

Wolfgang Munchau says we are back to the situation of February when markets expected a sovereign default in the euro area, with the exception that this time the willingness of the euro area to help is much reduced, due to Greece’ permanent and aggressive flouting of the stability pact, and the embarrassing revisions of its deficit figures. The euro area’s strategy is now to put maximum pressure on Greece to comply with the rules, or face the prospect not to receive aid in case of financing difficulties. In other words, the strategy is to protect the stability pact – rather than Greece – and try to ring-fence the problem.

Martin Feldstein says that the widening spreads between the interest rate on German euro bonds and some of the other countries’ euro bonds reflect the market’s perception of the risk of default or of effective devaluation associated with leaving the euro. As the overall economy of the euro zone improves, the ECB will start to reduce liquidity and raise the short-term interest rate, which will be more appropriate for some countries than for others. Remaining in the euro zone could impose significant costs on some of them. At some point, the inability to deal with domestic economic problems within the EMU framework may lead one or more countries to conclude that those costs are simply too high to bear.

Silvia Sgherri and Edda Zoli (both from the IMF) argue that there is evidence that financial markets are increasingly sensitive to euro area country-specific solvency concerns. They find that changes in sovereign default risk premiums in the euro area continue to reflect mainly global risk factors – such as shifts in risk aversion in financial markets. But there is also evidence that the sensitivity of sovereign spreads to projected debt changes significantly increased after September, suggesting that the markets may now be able to provide more fiscal discipline than in the earlier years of the common currency. A recent paper by economists from DG ECFIN finds similar results and a paper by OECD economists suggests that the effects of fiscal performance on sovereign spread are non-linear, so that incremental deteriorations in fiscal performance lead to ever larger increases in the spread.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.


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