The Costs of Sovereign Default

IMF´s paper about the cost of defaults. It´s a must read and help us understand why the default is the "unavoidable" choise of Greece rather than the "strategic" default. And sooner or later the least expensive route. The ministers of finance of EU are pushing Greece in that way.

The evidence suggests that, while countries lose access (International Capital Market) during default, once the restructuring process is fully concluded, financial markets do not discriminate, in terms of access, between defaulters and non-defaulters.

First of all, default episodes may cause a collapse in confidence in the domestic financial system and may lead to bank runs, resulting in banking crises or at least a credit crunch. Second, even in the absence of a bank run, default episodes would have a negative effect on banks’ balance sheet, especially if holdings of the defaulted paper are large, and lead banks to adopt more conservative lending strategies. Finally, default episodes are often accompanied by a weakening of creditor rights or at least more uncertainty about them, which, may also have a negative effect on bank lending.

Defaults tend to be widely anticipated and happen at times when the domestic economic is quite weak. This may happen for two widely different reasons. Self-interested policymakers may try postponing defaults even at increasing economic cost, as the evidence presented in this paper suggests a clearly higher political turnover following a debt default. A different possibility is that policymakers postpone default to ensure that there is broad market consensus that the decision is unavoidable and not strategic. This would be in line with the model in Grossman and Van Huyck (1988) whereby “strategic” defaults are very costly in terms of reputation—and that is why they are never observed in practice—while “unavoidable” defaults carry limited reputation loss in the markets.

Hence, choosing the lesser of the two evils, policymakers would postpone the inevitable default decision in order to avoid a higher reputational cost, even at a higher economic cost during the delay.

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