Presenting The Sovereign Default Equivalent Of The "Hindenburg Omen"
While the merits of its conclusion are at best questionable, and at worst, completely worthless, the IMF study presented earlier provides one statistical curiosity vis-a-vis sovereign defaults. Specifically, in "Default in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely" the author Carlo Cottarelli presents an observation which could be classified as a "Hindenburg Omen" type of signal for sovereign default. Unlike the real H.O. observation (which incidentally has now been experienced 5 times in the past three weeks) for stocks, the one relevant for sovereign bankruptcy has a much simpler gating threshold: 1,000 bps spread in credit risk. And just like in the Hindenburg Omen, this is a necessary (but not sufficient) condition for a crash: only in this case it is not the market that collapses, but a country's solvency. Cottarelli finds that since the first Brady deals in 1991-92 there are 36 instances in which a country’s spreads rose above 1,000 basis points. "Of those instances, seven eventually resulted in default; in the remaining 29 cases, however, the spreads stayed high for a few months and eventually fell back well below 1,000 basis points, with no default." The 1,000 is logically an inverse gating factor: no single country defaulted with spreads being below the 1,000 threshold. In other words, once a country passes 1,000 bps, it has a one in five chance of defaulting, roughly in line with the crash expectations of the traditional Hindenburg Omen.
This is visualized on the following charts:
Some more observations from the IMF:
Absence of default does not always mean smooth sailing: many of the countries experiencing high spreads required support from the international community, including large-scale IMF-supported programs. But the point here is that default was avoided in the majority of instances initially identified by markets as warranting bond spreads in excess of 1,000 basis points.
The list of prominent averted defaults includes, for example, Mexico (1994–95), Korea (1997), Brazil (1998–99 and 2002) and Turkey (2000–01). Brazil in 2002 provides the clearest illustration of default fighting. With high and growing debt ratios, political uncertainty, and a difficult international environment, sovereign bond spreads surpassed 2,000 basis points in the summer and fall of 2002. Yet, with fiscal effort, help from the international financial institutions, and the gradual establishment of a new policy track record, the spreads eventually fell below 500 basis points by late 2003 and declined further in later years.
Of course, the higher the sovereign spreads rise, the greater the proportional default possibility. We would be more curious to find out what the definitive threshold is beyond which a default inevitably follows. Furthermore, with Greece constantly flirting with the 1,000 spread, one would think the country only has a one in five chance of defaulting, yet in reality it would be long bankrupt were it not for the endless intervention of the IMF, ECB, EU and the Fed. And a more philosophical question: in this world of central (bank) planning do risk spreads even mean anything. In fact, is price discovery relevant at all when the Fed's tentacles reach out to every asset class? And taking the philosophical question to the extra difficulty level, one may ask, does anything have value when the Central Bank backs it up and what happens to "value" when the CBs finally withdraw, either voluntarily or involuntarily.