A huge wave of sovereign defaults might be coming

REUTERS/Philip Massie

Oil prices are around seven-month highs.

Both West Texas Intermediate crude and Brent closed around $47-$48 per barrel on Wednesday.

But if folks think that this might be the end of all of their commodity problems, then they may want to think twice.

In a recent note to clients, a Macquarie Research team argued that the global economy may go through a "wave" of sovereign defaults, given that something similar happened several decades ago.

"The last great collapse in oil and commodity prices from the end of the 1970s led to a decade-long wave of sovereign defaults. We believe another wave is coming, involving multiple debt restructurings over many years," the team wrote.

The team notes that in the 1980s, some countries were not keen to address the fiscal deficits resulting from lower tax revenues — and so, about a dozen countries watched public debt to GDP balloon to over 40%.

Since global capital markets mostly consisted of fixed exchange rates and national controls on capital flows at the time, collapsing exports led to shrunken FX reserves and current account deficits.

Here's what that looked like back in the day:

REUTERS/Philip Massie

As for today, this is how things could play out step by step for countries that heavily depend on oil and commodities, according to the Macquarie team:

1. Lower export prices could lead to current account deficits, which could then inspire policy makers to depreciate their currencies. Notably, OPEC members Saudi Arabia and Nigeria still have their currencies pegged as of this article's publication.
2. The depreciation could be about 30% to 50%, which could cause a spike in inflation and a need for nominal local interest rates to increase.
3. Policymakers might not be too excited about increasing rates quickly, as they'll be worried about economic growth. But capital outflows and an increase in sovereign-risk spreads will eventually lead to tighter monetary policy.
4. The fiscal situation will get worse with less oil-related taxes and a weaker economy. And the unwillingness to cut public expenditures will be reinforced by the tightening of monetary policy's negative impact on economic growth.

"At this point fiscal deficits become persistent. The ratio of public debt to GDP begins to trend higher," the team wrote. "As the public debt/GDP ratio rises over time, then the required primary budget balance becomes bigger, e.g. at 100%, not 50%, the required primary balance would be a surplus of 5% of GDP, not 2.5% of GDP."

As an end note, we would like to emphasize that just because something happened in the past doesn't necessarily mean that it will happen in the future. Today's world is not identical to yesterday's.

Still, it's interesting to consider the scenario.

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