Intro: Fiscal crises come in many forms depending on the currency denomination of the government debt load, the level of foreign ownership of that debt, and crucially the political response.
While every government debt default ultimately triggers a fiscal crisis, fiscal crises can occur in the absence of a default. Fiscal crises are best defined by periods when a government is forced to undertake drastic spending cuts and/or tax hikes in or order to prevent debt default or uncontrollable inflation. There is no guaranteed level of debt that will trigger a crisis because the currency denomination and ownership of the debt plays a key role.
Local Currency Debt – Government debt that is denominated in the currency in which the central bank can create at will can always be repaid, and central banks will almost always oblige the government to purchase their bonds. With the exception of Russia’s default in 1998, local currency debt crises are characterized by extreme austerity measures that become politically palatable as the only solution left to prevent uncontrollable inflation and an economic catastrophe. It is important to understand that while such austerity measures tend to be followed by further economic weakness, they actually help to prevent even more catastrophic damage occurring in their absence.
Foreign Currency Debt – Fiscal crises resulting from high levels of foreign currency debt are typically much quicker to arise as central banks do not have the luxury of creating money to purchase the debt, which makes them unable to prevent a sharp rises in the interest that the government must pay on their external debt. Higher interest rates on foreign currency debt can quickly become unsustainable as increased amounts of tax revenues are used to pay for debt repayments. If spending cuts and tax increases cannot maintain foreign investor confidence that debts will be able to be repaid, default will occur in the absence a bailout by the IMF or some other benefactor.
Another factor to bear in mind is the ownership of the government debt. Even if the debt is denominated in domestic currency and thus the probability of default is negligible, who actually owns this debt can have significant implications for the economy.
Roughly half of US government debt is owned by foreigners, which is very high compared to Japan where the figure is roughly 5%. With foreign investors owning such a large share of US debt, higher interest rates act as a drag on the economy as they increase the amount of dollars that the Treasury must send overseas, weakening the exchange rate and giving increased purchasing power to foreigners at the expense of US citizens.
Contingent Liabilities (SOEs And Banks)
Another consideration is the amount of SOE debt that a government guarantees. Brazil is a good example of where a high level of debt at state owned oil company Petrobras helped trigger a fiscal crisis as the government was ultimately on the hook for the company’s bonds. Similarly, countries with large liabilities relative to the size of the economy can also experience fiscal crises in the event of banking crises even though the official fiscal accounts are in otherwise solid shape, as the government will likely ultimately have to assume a share of these liabilities.
Fiscal Crises Provide Opportunities and Risks
Countries which have been through fiscal crises and been forced to cut spending often experience resurgent growth as the private sector tends to benefit from greater resource availability that was previously under the stewardship of less efficient government bureaucracies. However, much depends on the political backdrop. For every country that has been able to face a fiscal crisis and undertake the necessary reforms to enable a strong recovery, examples can be found of a country heading down the road of authoritarianism to prevent economic weakness from undermining their power.