Yesterday’s announcement of a likely default by Dubai World, the conglomerate owned by the government of the Gulf emirate, has come as a shock to investors, judging by the reaction of markets today.

Broad equity indices in Europe have fallen by 2-2.5%, while the Stoxx website tells me that the European banks supersector index is down over 4%.

According to a participant on a conference call last night with the issuer, quoted on the Naked Capitalism blog, “The standstill announcement…was a massive surprise. One could sense the panic in those asking questions….this could be the turning point in spreads and could be viewed similar to the Russian debt crisis in 1998 or the Bear situation in 2007…based on companies and the accents of the people asking questions, it is obvious European institutions will be hit hard.”

A commentator on the same blog argues that a more appropriate historical comparison may be with the Creditanstalt default of 1931, the event that many take as having triggered the 1930s depression.

To add insult to injury for affected creditors, the Dubai government had earlier raised US$5 billion in loans from banks in Abu Dhabi, which most had assumed was to be used to retire the Dubai World bond due in December. Strange behaviour for those third party observers expecting repayment, but perhaps not by an issuer expecting to be shut out of the capital markets after defaulting...

Is the debt crisis moving from the financial sector into the sphere of sovereign issuers?

I’m reminded of a recent interview I read with Kenneth Rogoff and Carmen Reinhart, whose recent book “This Time is Different: Eight Centuries of Financial Folly” is a bible for those seeking information on the history of government debt.

In the interview with the Public Broadcasting Service, Rogoff says: “Will there be something worse down the road? We probably won't have a relapse into the same kind of panic we saw at the end of 2008. After all, the governments of the world have basically guaranteed a huge patch of the financial sector."

“The bad news is government debts are soaring. In our book we show that, on average, government debt nearly doubles in the aftermath of a severe financial crisis, within a few years. We are looking at trajectories for government debt (relative to income) that are seldom seen outside of a war period."

“Will rich country governments, already facing severe long-term budget problems due to ageing populations, be able to tighten their belts enough to stave off a major problem? Maybe, but we are not so sure. Waves of international banking crises are often followed, a few years later, by waves of government defaults (on external debt).”

Credit default swap spreads on Dubai government debt have already jumped by more than 200 basis points in a couple of days to over 5%, with other regional sovereigns affected as well. And there’s been a sharp move higher in the cost of default insurance for G7 sovereign issuers, as we reported last week.

It’s still tricky for ETF investors to protect themselves against sovereign default risk (apart from by shorting the relevant bond market or by placing a negative bet on the currency concerned). The Markit iTraxx SovX Western Europe index now exists in a tradeable format, but so far the only transactions conducted are over-the-counter and between institutions.

If Rogoff and Reinhart’s exhaustive research is anything to go by, sovereign debt default could be the next big story.

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