When credit defaults are a good thing

History shows that sovereign credit defaults can sometimes be a good thing.

Defaults can be positive for the countries involved because they ultimately lead to economic reform and recovery, according to a report by Capital Economics.

The word "good," is, of course, subject to a series of conditions. And unfortunately for Greece, none of these conditions will be easy, or possible, to meet - a problem that could result in widespread default and inspire governments to break free from Europe's currency union, according to the report.

Historically, the ratio of debt to gross domestic product gets out of control when interest rates are consistently higher than growth rates. When countries are caught in a debt trap where the ratio rises astronomically, there's no way out except through very high inflation or a default.

The International Monetary Fund estimates Greece's debt ratio at about 150 per cent. Based on history, it's not possible to say when a country will default. Jordan waited until its debt ratio was at 180 per cent before it defaulted in 1989, whereas Albania defaulted a year later when its ratio was at only 17 per cent.

Governments tend to avoid defaults because of fears they will never be able to borrow again, the report says. Yet it notes that many countries have regained access to markets fairly soon after they've defaulted.

For a default to be a good thing, historically it should be followed by trifecta of significant debt writeoff, currency depreciation, and a "reasonably positive" global economy, the report says.

But the European Union and the IMF will postpone restructuring for as long as possible because a substantial debt writeoff would be a huge blow to the European financial system, said Craig Alexander, chief economist at Toronto-Dominion Bank Financial Group. North American banks would also prefer to avoid more economic trauma, he added.

Currency depreciation, normally the first step to avoid default, is also out of the question for Greece because of the EU currency union.

"Default without devaluation may simply prolong the agony," the report says. It predicts that periphery EU economies, such as Greece, will be forced to abandon the common currency in order to boost the appeal of their exports.

Others disagree and say the cost of exiting the euro zone is too high. "Leaving the EU is not a serious option," Mr. Alexander said. "It would be enormously damaging to the Greek economy."

Greece also fails to meet the third requirement of a "good" default, because the global economy continues to stall in recovery mode.

The short-term costs of a default include banking or currency crises, output decreases, capital flight, and tedious debt-restructuring negotiations, according to the report.

"Time frame is terribly important in terms of whether a default is a good thing or a bad thing," Mr. Alexander said.