Do sovereign debt ratios matter?(volatility & leverage matter more)

China Financial Markets ^ | 07/20/10 | Michael Pettis

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Do sovereign debt ratios matter?

Jul 20th, 2010 by Michael Pettis

Posted in Balance sheets, Banks, Financial crisis, History

In the past few weeks I have been getting a lot of questions about serial sovereign defaults and how to predict which countries will or won’t suspend debt payments or otherwise get into trouble. The most common question is whether or not there is a threshold of debt (measured, say, against total GDP) above which we need to start worrying.

Perhaps because I started my career in 1987 trading defaulted and restructured bank loans during the LDC Crisis, I have spent the last 30 years as a finance history junky, obsessively reading everything I can about the history of financial markets, banking and sovereign debt crises, and international capital flows. My book, The Volatility Machine, published in 2002, examines the past 200 years of international financial crises in order to derive a theory of debt crisis using the work of Hyman Minsky and Charles Kindleberger.

No aspect of history seems to repeat itself quite as regularly as financial history. The written history of financial crises dates back at least as far back as the reign of Tiberius, when we have very good accounts of Rome’s 33 AD real estate crisis. No one reading about that particular crisis will find any of it strange or unfamiliar – least of all the 100-million-sesterces interest-free loan the emperor had to provide (without even having read Bagehot) in order to end the panic.

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Perhaps because I started my career in 1987 trading defaulted and restructured bank loans during the LDC Crisis, I have spent the last 30 years as a finance history junky...

The world's worst quant?

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Good article. I think (hope) that sovereigns are less susceptible to the corrosive effects of credit derivatives and "Merton" modelling than corporates. In the case of corporates, the quants naively use stock price as a proxy for corporate asset value: and hence stock price vol as a proxy for asset vol. This causes a credit death spiral as volatile, falling stock prices imply worse credit which leads to more stock shorting. Thankfully spot FX and short term interest rates are close enough to reality for this effect to be dampened by "real money" buying. (E.g. purchasing power parity provides a soft boundary to FX weakness in open economies.)