Sovereign defaults and inflation

By fmiren | Is recession coming | 26 Oct 2023

Summary of finding about the sovereign defaults and inflation from "This Time is Different" by C. Reinhart & K. Rogoff


How to protect your crypto portfolio from inflation:


Below is a thread on the historical patterns that the book describes.

1. Historically, a frequent occurrence of global banking crises have been followed with high rate of sovereign defaults on external debt.

There are many ways global financial crises can lead to high incidence of sovereign debt crises worldwide, but especially in emerging economies.

- Banking crises in developed countries has tended to result in decreasing global growth which causes the commodity prices to drop. This fall in commodity prices affects negatively export revenues of commodity. As a result, their ability to service external debt is diminished.

- Herd behavior also plays a role in the channels through which financial crises lead to sovereign debt crises. Banking failures in one country may lead to credibility problems in the neighbor countries. Investors tend to overgeneralize the failure of one economy to other countries. They also avoid risky investments which is followed by capital outflows from emerging markets. That investors decrease their exposure when their wealth reduces is detrimental to emerging countries’ ability to service their sovereign debt.

- Banking crises in advanced economies have historically been associated with credit crunches. When money is scarce in these countries, it is difficult for emerging markets to borrow which results in weakening economic activity in these countries and increases debt burden.

2. There has been a clear historical pattern between inflation and sovereign external debt default. Countries that defaulted on external debt have limited or no access at all to global financial markets. And if prior to this, they hadn’t managed to decrease government spendings, they resort to inflation tax which sometimes even may result in hyperinflations. Therefore, inflation tends to worsen after sovereign default on external debt.

3. Since most emerging markets are commodity exporters, it isn’t surprising that commodity price cycles may lead the capital flow cycle. Troughs in the former may be followed by a high incidence of sovereign defaults.

Several researches have shown that there is a high procyclicality in emerging markets borrowing. The uptrend in prices of commodities tend to increased borrowing for emerging markets. When the cycle ends and commodity prices go down, capital inflow to these countries dries which leads to sovereign defaults.

The authors note that there’s a pattern found in the research on financial crises that countries experiencing “capital bonanza” (sudden capital inflow) are more likely to have a debt crisis.

4. Several words on domestic debt defaults. It may seem surprising but defaults on domestic debt are not that rare in economic history. Since the government can theoretically always inflate away its domestic debt, one may wonder why it chooses not to service the debt. But inflation can do more harm to financial sector. That’s why the government sometimes can regard the repudiation as a better choice.

Some conditions may render inflation much less desirable. If the debt is short-term or indexed, the government should achieve a more aggressive inflation to be able to drastically decrease the real payments of its domestic debt.

5. The authors compare the aftermath and the run-up of domestic and external debt defaults. Their conclusion is that in most aspects default on domestic debt is worse. For example, GDP has historically decreased 8% during the 3-year period before the default. If we look at the crisis year only, average output declines were 4 and 1.2 percent for domestic and external debt crises respectively.

According to Reinhart and Rogoff, the situation is much worse if we compare inflation during and after external and domestic debt crises. Historically, the year when external default occurred, the inflation rate was 33 percent. But it pales in comparison to the inflation during domestic debt crises. In domestic default the inflation rate has historically been 170 percent. That is 5 times higher than the inflation rate during external debt default! Even after the domestic default, the rate doesn’t fall to normal levels and remains above 100 percent after the crisis.

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commodity trader interested in crypto & writing about it

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