It takes less than a sovereign default to cause instability

Fabio Panetta, Giuseppe Grande, 7 August 2010



According to many commentators a sovereign default could be the next stage of the crisis (Reinhart 2010, Rogoff 2010 and Reinhart and Rogoff 2010). Indeed, the Greek crisis has highlighted the potential contagion effects of a sovereign default. Actually, it would take much less than a large-scale debt crisis to generate instability. The sheer size of the budget deficits that the main countries have been running since the outset of the crisis and the projected growth in their public debt in the coming years could trigger a significant increase in long-term interest rates, with severe consequences for the real economy and the financial system.

The risk of higher long-term interest rates

A worsening of the public finances can drive long-term rates up through the standard crowding-out of private investment as a consequence of large deficits. In the present circumstances two additional effects may be at work.

  •  First, an increase in public debt can generate fears of sovereign default, causing credit risk premiums to widen. So far, this effect has been limited to a number of small and weak economies, such as Greece, Portugal, and the Baltic states (although it has touched other countries, such as Spain), but there is a risk that it could extend to top-rated countries that have borrowed heavily to finance bank rescues and economic stimulus measures.
  • Second, the risk of deficit debt spiralling out of control can stoke expectations of inflation or currency depreciation, with additional repercussions on interest rates (Ardagna et al. 2007).

Econometric estimates of these effects vary considerably, depending on the country chosen and the methodology used. There is, however, a consensus that the increase in interest rates is greater if the deterioration in public finances persists over time. Studies for the US suggest that a permanent rise of 1 percentage point in the ratio of public debt to GDP would increase real long-term dollar rates by between 3 and 5 basis points (Laubach 2009); the effect of a permanent increase in the deficit to GDP ratio would be greater. The estimates available for European countries tend to be of the same order of magnitude or even larger (Chinn and Frankel 2007).

According to IMF projections, the public debt of advanced economies will rise significantly between now and 2013 (Figure 1). The planned consolidation measures will only mitigate this trend. In the US the increase would amount to about 30 percentage points of GDP. Based on the estimates cited above, this would imply, other things being equal, a rise of between 1 and 1.5 percentage points in real long-term rates.

Figure 1. Public debt as a percentage of GDP

Source: Based on IMF, World Economic Outlook (April 2010).

Yet these estimates may well be optimistic – in the present circumstances the impact on long-term interest rates could be much stronger than in the past.

  • For one thing, investors might well judge the current expansion of deficits to be very persistent.
  • Second, the relation between the public deficit and market yields could turn out to be non-linear: as the increase in the supply of public securities is substantial in absolute terms and involves all the main advanced economies simultaneously, it could result in larger interest rate increases as public debts grow. A vicious circle could arise between the cost and the level of the public debt, with higher debt causing an upward shift of the yield curve that would, in turn, put additional upward pressure on the deficit and the debt.
  • Third, the widespread perception that the crisis has reduced the growth potential of advanced economies (Chopra 2009) could fuel further doubts about the sustainability of public debts.
  • Finally, in the next few years a large volume of bonds issued by private companies, especially financial institutions, will have to be refinanced (Figure 2). This could make competition for funds between sovereign borrowers and private issuers particularly intense, increasing the difficulties for the former.

Figure 2. Private bonds maturing (billions of euros)

Source: Based on Dealogic data. Redemptions of medium-term bonds (with original maturity of 2 years or more) issued by private companies on domestic or international markets.

In spite of all these potential pressures, government bond markets in the major countries remain dangerously complacent. In the US and the UK, for example, where the public deficit has grown dramatically, 10-year yields are currently at historical lows (about 3% and 3.5%, respectively). In some countries (particularly the US), long-term bond yields have even fallen in recent months.

This apparent puzzle probably reflects extremely favourable demand conditions, which are, however, largely temporary. Since the onset of the financial crisis the government securities of the main advanced countries have repeatedly benefited from the so-called flight to quality, i.e. investors’ preference for low-risk assets. Safe haven flows have been fuelled by concern over the soundness of private issuers (above all banks) and, in recent months, by the deterioration of the fiscal conditions of non-core Eurozone economies. Furthermore, in some countries (such as the UK and to a lesser extent the US) central banks have made massive purchases of public securities. Finally, in many countries commercial banks have been buying government bonds in order to profit from domestic carry trade positions and to build liquidity buffers ahead of new regulatory requirements.

With the economic recovery and the phasing out of the current exceptionally expansionary monetary policies, these demand trends are likely to ease and gradually to change sign, exerting pressure on government bond yields. This effect will probably differ across economies, but could be significant even in countries where the prospect of an outright default is quite remote.

The implications for banks – and the economy

In this context, exposure to sovereign risk may well be the next problem for banks, even without large-scale sovereign defaults.

  • First, government bonds constitute a considerable share of bank assets: the deterioration in fiscal positions and the ensuing increase in yields could cause large mark-to-market losses in relation to capital. The stress tests recently completed in the EU have shown that, for some banks, capital could fall significantly, although the system as a whole would remain solid. Comparable figures are not available for the US, where the five largest banks hold government securities amounting to 8% of total assets and 94% of equity (based on banks’ quarterly accounts for the first quarter of 2010).
  • Second, government bonds are used in banks’ day-to-day operations as collateral for various transactions (repos, refinancing operations, margin deposits, etc.). A sharp deterioration in government-backed assets could therefore impair basic banking functions.
  • Third, higher long-term interest rates would inevitably translate into higher long-term bank funding costs, since these are typically determined as a spread over the cost of government paper.
  • Most importantly, banks are exposed to the systemic consequences of a persistently higher level of long-term real rates. The crowding out of private investment, the greater burden of interest payments on corporate profitability and household income, and the reduced leeway of fiscal policy could adversely affect the economy and thus increase the credit risk on banks’ assets. In such an environment, banks’ balance sheets could again come under extraordinary pressure.

How to get back on track

In conclusion, even without large-scale defaults by sovereign borrowers, the sheer size of the budget deficits that the main countries have been running since the outset of the crisis and the projected growth in their public debt in the coming years threaten to cause an increase in long-term interest rates that could derail the economic recovery, undermine the profitability or even the stability of banks and, ultimately, jeopardise the global economic system. Up to now, problems have only emerged for small and weak economies, yet the risk in the months ahead is that investor attention could switch to bigger, top-rated countries with large budget deficits.

Against this background, prolonging the fiscal stimulus and failing to come to grips with the damage done to public finances may well have undesired consequences for the real economy and the financial system (Trichet 2010). In order to preserve stability, governments must strengthen their efforts to achieve fiscal sustainability, restore the health of banking systems, and foster growth.


Ardagna S, F Caselli and T Lane (2007), “Fiscal Discipline and the Cost of Public Debt Service: Some Estimates for OECD Countries”, The B.E. Journal of Macroeconomics, 7(1), 28.

Chinn M and J Frankel (2007), “Debt and Interest Rates: The U.S. and the Euro Area”, Economics Discussion Papers 2007-11.

Chopra A (2009), “Potential Output: Worrying About What Cannot Be Observed”, iMFdirect, 13 August.

International Monetary Fund (2010), Global Financial Stability Report, Washington.

Laubach T (2009), “New Evidence on the Interest Rate Effects of Budget Deficits and Debt”, Journal of the European Economic Association, 7(4):858-885.

Reinhart CM and KS Rogoff (2010), “From Financial Crash to Debt Crisis”, NBER Working Paper 15795.

Reinhart CM (2010), “Eight hundred years of financial folly”,, 5 May;

Rogoff KS (2010), “Europe finds that the old rules still apply”, Financial Times, 6 May.

Trichet J-C (2010), “Stimulate no more – it is now time for all to tighten”, Financial Times, 23 July.


Topics: Global crisis, Global economy
Tags: Debt crisis, Eurozone crisis, Fiscal crisis, sovereign default

Deputy Manager in the Department for Economic Outlook and Monetary Policy at Banca d'Italia

Head of the Department for Economic Outlook and Monetary Policy, Banca d'Italia