In the case of China, and several other countries, the currency regime has led to explosive lending growth, speculative real estate and stock markets, a large “informal” banking system, and inverted domestic debt structures.  It also seems to be leading to a rapid rise in inflation, although there is still a sharp debate about how serious this inflation is likely to be.  These can easily create the conditions for the kinds of financial crisis which occurred, for example, in the US during much of its developing stage.  The US suffered from financial crises nearly every 10-15 years, in some cases extremely damaging crises (the 1790s, the 1830s, the 1870s and the 1930s, for example), but they were never external debt crises, mainly because the US had little external debt.

 

Fourth, successful countries, i.e. countries that have managed to make the transition from developing to developed economy, have generally had limited experience with sovereign defaults.  That might seem obvious at first, but it is not so obvious where the causality runs.  As the authors write: “Do high growth rates help avert default, or does averting default beget high growth rates?” (pp.16)  At least part of this answer must have to do with the special damage caused by sovereign default.  It is worth noting that the United States, one of the most economically successful countries in history, has a very low incidence of sovereign default, but, as I mention above, it does not have a low incidence of system-wide financial crises.  On the contrary, the US, especially in the 18th and 19th centuries seemed to have had financial crises fairly regularly (and by some accounts still does), but they rarely if ever involved the federal government debt.

 

Why?  Is it because the US government was particularly prudent and/or careful?  I doubt it.  I suspect it has a lot more to do partly with the peculiarities of US political life such that for much of its history the central government struggled with the states over centralized power, including over its fiscal role, and partly with the deep distrust Americans had until the middle of the 20th century for banks and for government debt – after all Andrew Jackson won his 1836 campaign largely on opposition to the Bank of the United States, a quasi-central bank that was closed down when its charter was not renewed in 1838.  Until recently the US government simply did not have enough debt on which to default – most debt was at the state, municipal, and corporate level, but at the state and corporate level there were more than enough defaults to satisfy any historian.

 

My own theory is that sovereign debt crises are an especially brutal kind of crisis because when the central government is in default, or perceived to be near default, the country suffers from a whole set of financial distress costs that make it very difficult for the financial system to clear.  In those cases every domestic borrower, even healthy ones, suffers from capital flight and disinvestment, and the economy cannot begin again to grow until the sovereign credit has been substantially repaired, unlike the kinds of financial crisis that affected, say, the US, in which there was no or little perceived threat of a sovereign default.  In that case after the crisis bottomed out investors were not afraid to snap up cheap assets and restructure troubled companies and, in so doing, they restored economic growth.  This does not happen when the central government is in default.

 

I won’t go into it in too much detail (again I discuss this extensively in my book) but one conclusion is that the sovereign credit must be protected at all costs.  For that reason governments should push as much borrowing as possible off the central balance sheet, including, most importantly provincial, municipal and project-related borrowing.  In the case of China, it should probably cut its links to provincial and municipal borrowing as soon as it can and it should try to push the financing decision as far down as it can.  It should also refrain from protecting large borrowers from the consequences of their borrowings, although this may be culturally very difficult for an actively interventionist government to accept.

 

As good as the R/R paper is there are, inevitably, some things I would have liked to see discussed more.  For example there has not been much discussion in the R/R paper about the role of contingent liabilities in sovereign crises.  As a very interesting book published last March by the IADB (Living with Debt) notes repeatedly, very often the debt that “caused” the financial crisis was not the long-term accumulation of fiscal deficits but rather the very sudden emergence or conversion of contingent liabilities.  These contingent liabilities suddenly exploded – for a variety of reasons – and were generally structured in ways that exacerbated both the previous good conditions and the current bad conditions.  

 

The two most common forms of this have been the explosion in the relative value of debt denominated in foreign currency, following a currency crisis, and the explosion in contingent liabilities through a collapsing banking system.  In my opinion these have been two of the most common causes of “unexpected” financial crisis, and it is worth considering any country’s, including China’s, risk of either event occurrence.

 

China, of course, is in little risk of seeing the former happen.  With less than $400 billion of external debt and close to $2 trillion of foreign currency reserves, China is at no risk of a recurrence of the 1997 Asian crisis.  The real threat for China is in the second set of contingent risks, that of an explosion of liabilities arising though the banking system.  I am obviously not the first person to point this out – China’s massive loan growth and its stubbornly high NPL ratio in spite of what can only be described as a dream time for bankers suggests at the least that in a sharp downturn there is a very real risk of a surge in NPLs.

 

As a corollary to the third point I mention above R/R also argue, correctly, I think, that default probabilities depend not so much on the share of external debt to total debt but “much more on the overall level of debt.” (pp. 12).  This is true – one of my favorite books cited in their paper, Max Winkler’s 1933 Foreign Bonds: an Autopsy, points out that the only certain thing that can assure us that a country is unlikely to default on its debt is that it have no debt.  There is no other factor that is highly correlated with a low incidence of default.  

 

But the overall level of debt is not nearly enough to go on.  There are at least two very important additional issues to consider.  First, highly diversified, low-volatility economies can support much larger debt burdens than undiversified volatile economies. 

 

This is particularly true of commodity exporting nations.  R/R note that “favorable trends in countries’ terms of trade (meaning typically, high prices for primary commodities) typically lead to a ramp of borrowing that collapses into default when prices drop.” (pp. 31)  Although this comment is not directly applicable to China since China does not rely on commodity exports for its growth – however, as I have pointed out several times to me friends in Brazil, it is a very worrying comment for countries like Brazil – it does suggest that positive shocks in the current account are often accompanied by excess balance-sheet risk-taking, and when these positive shocks turn negative, as they always eventually do, there is a high risk of financial crisis.

 

Second, certain types of debt are volatility-enhancing while others are not, and some even volatility-dissipating.  The former include, for example, foreign currency debt, whose costs decline in real terms when the borrower’s economy is flourishing (as the real value of the local currency rises) but can shoot up sharply at exactly the wrong time when economic conditions turn down.  The latter might include long-term, fixed-rate local currency debt, whose servicing costs decline during an inflationary shock.  Because it can significantly increase volatility, it doesn’t take much of the former type of debt to create a high risk of default, whereas the latter is much less risky.  I discuss this in great length in Volatility Machine and it would take too much space to discuss it even briefly here, so I will simply note that the structure of debt is at least as important as the amount of debt in determining the risk of a debt crisis.