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Sovereign risk

Discussion note 5 - 18 March 2011

Government debt has increased sharply in most developed countries in the wake of the financial crisis. The increased debt burden comes on top of an expected surge in debt due to demographics. Sharpened by the European peripheral debt crisis, this has led to increased focus on the risk associated with investing in government debt. This section reviews measures of this risk and discusses possible implications for investment returns.

Main findings

  • A continuation of current policies in most developed countries is unsustainable. This is mainly due to today‚Äôs high debt-to-GDP ratio and an ageing population incurring costs in the future. 

  • In order to bring the debt-to-GDP ratio onto a sustainable path, governments need to change policies, default on debt or expropriate assets. The mix of th options a government chooses will have implications for investment returns.

  • Empirical evidence shows that governments historically have both defaulted on debt and expropriated assets, but usually opt to change fiscal policies. 

  • Constructing measures that predict when governments will choose the default-on-debt option is challenging. In developed economies, validating such a measure empirically would in any case be difficult since defaults are almost non-existent.(1)  As a group, developed economies are, however, in a new situation: the debt-to-GDP ratio is higher than ever previously observed and significant policy changes are needed to make policies sustainable (IMF 2010a).

  • Some indicators, albeit noisy, do indicate that the default risk on government debt in developed economies has increased, and it should be noted that even a small increase in this default probability can change the way investors construct portfolios and price risk: the premise that a risk-free investment exists, which is an important building block in portfolio theory and management, may no longer be valid (Damodaran 2010). 

  •  Even if we still judge the risk of outright defaults on government debt in the developed economies as fairly small, the high and increasing debt levels may imply a weak real return outlook in developed countries.(2)      

1) The last defaults in the industrial world were Japan and Germany in the immediate aftermath of World War II (Reinhart and Rogoff 2008).
2) Reinhart and Rogoff (2010) find that a high debt-to-GDP ratio is associated with low real economic growth.

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