Understanding Systemic Risk in Global Financial Markets. Gottesman Aron

negative impact on a country that defaults on its debt can be significant and long lasting. For example, it took Russia decades to finally resolve its 1918 external default with creditors. In addition, because of Greece's default in 1826, the country's access to global capital markets was very limited for the next half century.

      As one of the goals of this book is to identify tools that will help financial industry participants identify the early signs of a financial crisis, it is worth noting that episodes of sovereign default have exhibited some noticeable macroeconomic trends prior to the actual default event. The average total decline in domestic GDP during the three years prior to domestic debt defaults is 8 %, compared to an average decline of 1.2 % for external defaults. Meanwhile, inflation averages 170 % during the year of a domestic default versus 33 % for external debt crises.25

As shown in Table 2.3, Spain and France led Europe in defaults between 1800 and 2008, similar to what occurred prior to 1800. Furthermore, starting in 1800 there was a significant increase in the volume of external defaults globally. This trend may be attributed to many factors, including the development of international capital markets and the establishment of many new nations.

Table 2.3 Cumulative Defaults and Reschedulings: Europe and Latin America (Year of Independence to 2008)26

      Since 1800 there have been several distinct periods of high sovereign defaults:

      ● Napoleonic wars

      ● 1820s–1840s

      ● 1870s–1890s

      ● Great Depression era: 1930s–early 1950s

      ● Emerging markets: 1980s–1990s

      INTERNATIONAL CONTAGION

      Financial crises throughout history were often not an isolated event geographically. This is because countries around the world are often linked in a number of ways. Furthermore, very often crises are fueled by more than one of the categories we are discussing in this chapter. Often it is the combination of several of these drivers that ultimately leads to systemic events. As one example, during the period of 1900 to 2008, there was a high correlation between the percentage of all countries experiencing a default on their external debt and those countries that suffered a banking crisis in the same year. Some potential explanations for this linkage include:

      ● When a developed nation experiences a banking crisis it tends to have a substantially negative impact on global growth, which hurts exports of smaller emerging market countries, making it more challenging to service external debt.

      ● Banking crises in large countries tend to lead to reduced lending and capital flows to less-developed nations, which can strain their debt service capacity.27

      Arbitrage connects national markets; the implication of the law of one price is that the difference in the prices of identical or similar goods in various countries cannot exceed the costs of transport and trade barriers. Similarly, the security markets in the various countries are also linked, since the prices of internationally traded securities available in different national markets must be virtually identical after a conversion of prices in one currency into the equivalent in other currencies at the prevailing exchange rates. Some examples of international transmission mechanisms include: