Thursday, June 23, 2011

Default Explained

Readers Question: What is “the default”, which BBC likes to talk about, but never explains?

On the BBC, there is much coverage of the current issue of 'debt default'. This refers to government debt and the possibility the government may not be able to pay back the debts it owes.

It's the same principle as an individual borrowing a significant amount of money, but then being unable to pay back the debt. Therefore they declare bankruptcy and don't pay their loans back.

In recent years, Governments have spent more than they receive in tax. When a government spends more than it receives in tax, they meet this shortfall by borrowing from the private sector. They borrow money by selling bonds. These bonds are bought by private investors, banks and investment trusts.

They lend the government money because the government pay interest on bonds. Government bonds are usually seen as a secure way to invest money and get interest in return.

Government budget deficits have increased after recession of 2007.

However, some countries like Greece and Ireland have seen a very sharp rise in the amount of government debt as a % of GDP. Markets have become worried that they will be unable to pay the interest on these debts and raise enough money to funds its deficit. Greece have tried to reduce its budget deficit by cutting spending, but this has caused a recession and higher unemployment. Markets feel Greece debt is so high they won't be able to bring government debt under control by cutting government spending because even if they cut spending sufficiently, this severely damages the economy.

Default and Interest Rates.

If markets think there is an increased chance of debt default, demand for bonds will fall, leading to higher interest rates. If you look at graph here - Problems in Monetary union, you will see that interest rates on Greek debt has been rising because of fear of debt.

Different Types of Default

To make things a little more confusing, there are different types of default.

Voluntary agreements to extend maturity of loans. This means that holders of government debt agree to extend the length of the loan, rather than getting repaid in 3 years, they get repaid in 5 years. Therefore, the Greek government have longer to pay back their debts. They still have the same amount of debt, just longer to pay them back.

Partial Default / Haircut. Recognising the government cannot pay the full amount of debt back, holders of debt accept a cut in the value of their bonds, e.g. the government pay back just 70% of the value of their bonds. The bond holders may accept this partial repayment because they think it is better to get 70% of the debt than nothing. This is a partial debt default. (It is like a voluntary credit agreement where an individual pays a percentage of debt back rather than declare bankruptcy.

Full Default. A full default would be when the government is bankrupt and can't pay anything at all. Bond holders would lose everything and it would cause a widespread collapse in confidence in European governments ability to repay debt.

In the case of Greece, there is a big debate about whether they should have some kind of default.

Some argue that The debt to GDP ratio is rising so high, the government have no chance of getting this under control. Unfortunately, the Greek governments attempt to reduce their budget deficit (cutting spending and increasing taxes) has pushed the economy into recession, meaning it is harder to raise tax revenues.


1 comment:

Pan said...

You say that when markets doubt the ability of the government to pay off its debts,the demand for bonds fall as a result of which interest rates rise.What interest rates do you mean here?