Challenge

Just over a decade has passed since the sovereign debt crisis first gripped Europe, but the scenes feel all too fresh: Runs on banks, austerity measures, skyrocketing unemployment.

Though much has changed since the onset of the European debt crisis—most notably Brexit—the United Kingdom’s economy remains interlinked with Europe’s. As new major global threats imperil the continent’s economic health, we ask: What would happen if a eurozone country defaulted on its debt?

A recent PGIM survey found that such a default—a low-probability event with outsized potential to derail markets—would be a top tail risk for institutional investors in the UK.

Sovereign debt defaults aren’t beyond the realm of possibility. Borrowing increased during the pandemic, and 2020 saw the largest one-year global debt surge since World War II. The euro area’s debt-to-GDP ratio declined in the first half of 2022, but at 94.2%, it’s still significantly elevated above its 2019 level: 83.6%.

Fortunately, the apparent riskiness of European public debt hasn’t climbed as steeply. Jagjit Chadha, Director of the UK’s National Institute of Economic and Social Research, says that the risk of default could rise as quantitative easing starts to unwind, but in his view, chances of a repeat of the debt crisis are slim. The threat is likely to take on a new form. 

“The biggest risk is that we’ve entered a regime in the last 12 years of very low interest rates, and we’re moving back to normal rates,” he says. “That movement will trigger events in different financial markets in ways we haven’t anticipated.” In the UK, a prime example is the liability-driven investing-fueled collapse in the pension fund market.

Rather than preparing for a single-country default that triggers a domino-effect contagion, Chadha advises investors to envision eruptions occurring in multiple markets simultaneously as interest rates normalize.

Impact

Despite Brexit, a crisis in the eurozone would directly involve the United Kingdom. Post-Brexit, the UK is no longer required to contribute to the EU budget—but Chadha suspects that debate would arise as to whether it ought to. As an IMF member, the United Kingdom would still contribute to a bailout loan, and the Bank of England would join other central banks in providing swap lines for liquidity.

The biggest impacts would stem from the economic fallout in Europe. Defaults typically lead to recessions, and the contraction could lead to lower-than-anticipated euro area interest rates and a resulting depreciation of the euro. Exports would contract—heightening the contractions the UK has already experienced since Brexit.

“It would be a further knock to productive growth in the UK,” says Chadha. “It would be a shock, and presumably lead to some loosening of monetary policy.”

As the eurozone remains a major trading partner of the UK, the changes would rattle markets at a time when the country is already contending with its own economic trials.

“The word of the year this year in the UK is ‘perma-crisis,’” reflects Chadha. “Brexit, Covid, the war, the energy crisis—all of those things have not only acted to reduce productivity below where it would otherwise be, but have interacted with each other so that every successive crisis has more of a negative output consequence than the previous one might otherwise have had.”

Takeaway

While the European debt crisis holds important clues to the ripple effects of a eurozone default on the UK and beyond, we shouldn’t expect a crisis to happen the same way twice. The lesson to learn, Chadha says, is that there may be a lot more volatility than anticipated in many markets—and as quantitative easing unwinds, risk may rise.

“Markets are adjusting to higher interest rates against the backdrop of high levels of government debt and populism,” Chadha explains. “Populations are demanding support after Covid and in the middle of a war that will be very expensive. All of that is going to lead to issues in various markets.”

It’s enough to invite reevaluation from investors, and Chadha encourages considering new strategies to navigate a changed economic landscape—one in which crises intersect and compound one another, driving more extreme outcomes. The confluence of slower economic growth, normalized interest rates—around 4%-5%—and persistent inflation may necessitate shifts in investment targets.

“If you are demanding the returns that you’ve had in the last 10 years in a climate where that might not be possible,” he cautions, “you might be forcing more risk onto your investment strategies than you’re prepared to take.”