Are sovereign defaults the next stage of the crisis? In their extensive studies of financial crises, Carmen Reinhart and Kenneth Rogoff had pointed out that global banking crises have historically been associated with sovereign defaults of external debts. The true cost of banking crises, they say, lies in the rise in public indebtedness.

In their paper—The Aftermath of Financial Crises—Reinhart and Rogoff clearly warn, “The global nature of the crisis will make it far more difficult for many countries to grow their way out through higher exports, or to smooth the consumption effects through foreign borrowing. In such circumstances, the recent lull in sovereign defaults is likely to come to an end." That’s not all—in another paper, they point out that “concluding that countries like Hungary and Greece will never default again because ‘this time is different due to the European Union’ may prove a very short-lived truism".

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Much depends, of course, on the nature of the public debt. It has been argued, for instance, that the reason Japan has not defaulted so far despite its very high debt to gross domestic product ratio is because almost all its debt is domestic. But, ultimately, risk is where the leverage is. In the last couple of years, excessive levels of private sector debt have been converted into public sector debt. That is why the risks are now perhaps the highest in the sovereign credits of over-extended Western governments.

Willem Buiter, now chief economist at Citigroup Inc., had in his blog with the Financial Times said that the threat of sovereign default is a real one because the European Central Bank “will not monetize the government debt and deficits of small European area member states".

The irony is that many countries will be caught in an unpleasant dilemma. If they reduce their fiscal deficits, they will risk years of low growth and perhaps social unrest. If they don’t reduce fiscal deficits, their borrowing costs will zoom. Government bailouts are not costless, after all. That is the lesson the markets are now learning.

How can this affect emerging markets? A recent issue of Barclays Capital’s Emerging Markets Weekly says that although emerging market sovereign balance sheets are in comparatively better shape and that the long-term trend in asset allocation to them holds, lower growth in the core countries because of forced fiscal adjustments may affect growth for emerging markets. It also says, “In the short term, however, the repricing and redefinition of sovereign risk in the euro area, and possibly other large advanced economies, seems likely to keep risk assets pressured. Price action in emerging markets (EM) so far reveals that there is little differentiation between good and bad in EM."

But EPFR Global points out that while investors fled emerging market equities, they continued to pour funds into emerging market bonds. That’s an indication that high valuations, as much as risk aversion, have had a part to play in the retrenchment from emerging market equities.

Graphics Ahmed Raza Khan/Mint

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