Is a wave of sovereign defaults on the way?

The sovereign debtor that would win hands down a nomination as “most likely to fail” is surely Greece, which has just threatened to default on its next payment to the IMF. But Greece could be a distraction – history suggests sovereign default risk is rising elsewhere, and that a wave of such defaults could be on the way.

Contemplate for a moment the following graph produced by Oxford Analytica, as part of the publicity materials for their new online tool that prices political risk. The graph tracks three indicators over time: oil prices, expropriations of foreign direct investment, and sovereign defaults.

Oil price and CEN

The relationship between oil prices and these two types of country risk is strikingly apparent. When oil prices rise, governments move to expropriate. High oil prices mean that natural resource investments are suddenly spectacularly profitable, and seizing these investments therefore becomes increasingly attractive. In the 2000’s, regimes from Kazakhstan to Chad to Russia to Bolivia indulged this temptation, and not only in oil – some mining investments, also with soaring profitability, were similarly nationalized.

High oil prices also give cover to governments wishing to pursue extremely unorthodox economic policies. Venezuela, which seized not only oil but much foreign investment in the country, stands out as a recent example.

On the graph, the link between oil prices and expropriation is obvious in the mid-1970s: expropriations peaked just after oil prices surged. The link is apparent again in the 2000’s, as a second surge in oil prices triggered another wave of expropriations, albeit with a less dramatic peak.

The relationship between oil prices and sovereign defaults is precisely the opposite. When oil prices fall, sovereign defaults soar. This relationship is also apparent in the graph: when oil prices plummeted from about $100/barrel in 1980 to below $40/barrel a couple years later, this touched off a surge in sovereign defaults – nearly 20 countries defaulted on their debts every year between the early 1980s and 1990.

This wave of defaults included much of Latin America (Argentina, Bolivia, Brazil, Chile, Costa Rica, Dominican Republic, Ecuador, Haiti, Honduras, Mexico, Nicaragua…) as well as other major emerging-market debtors worldwide (Ghana, the Philippines, Sri Lanka, Turkey…). First the countries dependant on oil exports defaulted; then the countries dependent on easy credit defaulted.

The graph ends in 2013 – when global oil prices were just about to plummet once again. Prices have now fallen from over $100/barrel to about $60/barrel. Will this plunge touch off another wave of sovereign defaults?

It looks like it. Credit default swap prices for Venezuela (as well as Argentina and Ukraine) imply a roughly 19% annual chance of default over the next five years, according to calculations by Deutsche Bank – which is close to a certainty. Russia is currently hovering around the 5 to 6% range. Not too bad, except when you consider that this is double the probability of six months ago (markets were a little slow to pick up on this risk).

The good news is that compared to the 1980s, emerging markets, especially those dependent on oil, tend to have relatively low levels of public debt. Russia and Nigeria are exemplars in this regard, with ratios of public debt to GDP around 10% (against more than 60% in Venezuela, which is sorely in need of a miracle, or about 50% in Chad, where the situation is worrying).

The really bad news is that other global conditions are currently moving in a dangerous direction. Recent analysis by Oxford Economics has shown a strong link between a strong US dollar and diminished capital flows into emerging markets. And an early warning model of sovereign default included in my new edited volume on country risk shows that interest rates on US treasury bills are the second most powerful indicator of emerging economy sovereign defaults. Both of these indicators, in effect, suggest that for emerging economies, over the next year or so, liquidity is about to dry up.

The waves of expropriations and sovereign defaults that occurred in the 1970s (following the oil price rise) and 1980s (following the oil price collapse) were cataclysmic. The expropriations claimed nearly every major foreign investment in the natural resource sector of emerging markets. The sovereign defaults would have caused the collapse of the US banking system – if not for a US government bailout.

The recent echo of the 1970s expropriations was much milder. We can hope we are as fortunate with the coming wave of sovereign defaults – that Argentina, Venezuela and Ukraine are the only casualties. But, on current trends, I wouldn’t count on it.