Do defaults matter?

With talk of sovereign debt defaults abound, it is probably useful to consider the impact of such defaults. The Economist provides some useful insight into this from one of their recent Economics Focus pieces.  They suggest that defaults aren’t catastrophic at all.  The piece is here and this is a short extract.

Defaulting does affect the cost of funds to a country. A study in 2006 by a trio of economists at the Bank of England found that countries which defaulted between 1970 and 2000 had both a higher bond spread and a lower credit rating in 2003-05 than countries with the same debt-to-GDP ratio which did not default. In their study Messrs Borensztein and Panizza show that having defaulted is associated with a credit-rating downgrade of nearly two notches. Using data for 1972-2000, they also find sizeable jumps in bond spreads after a default. In the first year spreads widen on average by four percentage points. This additional cost declines to 2.5 percentage points the year after. These figures may understate the pain, however: as the Greek case shows, worries about default are enough in themselves to lead to an extended period of high spreads.

That said, markets appear to have short memories. Only the most recent defaults matter and the effects on spreads are short-lived. Messrs Borensztein and Panizza find that credit ratings between 1999 and 2002 were affected only by defaults since 1995. They find that defaults have no significant effect on bond spreads after the second year. This tallies with earlier research by Barry Eichengreen and Richard Portes. Studying bonds issued in the 1920s, they also found that recent defaults resulted in higher spreads but more distant ones had no effect.

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