Sovereign defaults will be felt globally

22 February 2010

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The extraordinary measures taken by policy makers during 2009 have played a significant role in stemming the financial crisis and rebuilding the financial system. But these actions have also effectively transferred debt from the private sector to government balance sheets.

This transfer has been explicit in the case of bank nationalisations and retail deposit guarantees, but also implicitly in terms of rhetorical support for troubled banks. Clearly all this support would be heavily questioned if a developed market subsequently defaulted on its own debt.

If a sovereign default were to occur, the initial concern would likely be on the country’s banking system, which is particularly susceptible to confidence shocks.

Presumably, international banks would be supported by international bodies to the extent that their failure would directly affect other countries.
Domestic banks, however, may be allowed to fail. The broad economic impact would take longer to play out, but with the defaulting nation being forced to cut spending and increase revenues, there would be a severe impact on domestic activity.

Of even greater concern is the fact that if one country defaults, then others may follow. Similar problems of high national debt levels currently beset a number of countries. So just one default could cause a domino affect.

With the lessons from the collapse of Lehman Brothers still fresh, it is possible that strong countries will take significant measures to ensure the first sovereign default never happens.