In the August 2009 edition of MarketViews, we predicted that huge government borrowing in the developed world would shape the global economy over the next decade. The question we posed at that time was whether the rich world’s governments would be able to contain their debt burdens through budgetary discipline or if they would be tempted to turn to inflation or even forced to default.

Since August events have moved quicker than anticipated. Although we focussed on the big developed countries in the August edition, concern around the rapid deterioration of the finances of the US, UK and Japan has been temporarily overtaken by sovereign crises in Dubai and now the weaker Eurozone members, the “Piigs” – Portugal, Italy, Ireland, Greece and Spain.

Greece in particular has occupied headlines over the last month as bond vigilantes have forced up yields on its debt and made default a topic of open discussion. Journalists are also apparently delighted that it had teamed up with Goldman Sachs - the arch-villain of financial markets – to sneakily raise $1bn of off balance sheet financing and so make its debt-to-GDP ratio appear healthier.    

Lessons from history

Kenneth Rogoff, a former chief economist at the International Monetary Fund, co-authored a book in 2009 called “This Time Is Different.” The book charts the history of financial crises in 66 countries and shows that after almost every banking crisis there are usually a number of sovereign defaults.

At a speech in Tokyo on 24th February he reiterated this view in the light of developments in Greece. “We almost always have sovereign risk crises in the wake of an international banking crisis, usually in a few years, and that’s happening,” he said. “Greece is just the beginning.”

The fallout from a potential default would be huge for the global financial system - Greece’s debt totaled $405bn at the end of 2009, according to the Finance Ministry. That’s more than five times what Russia owed when it defaulted in 1998 and Argentina when it missed payments in 2001.

Rogoff expects that Greece will eventually be bailed out by the IMF rather than the European Union. Greece will probably announce an austerity program “in a few weeks” that will prompt the EU to provide a bridge loan which won’t be enough to save the country in the long run, he said.

The Big Boys

Global scrutiny of sovereign debt has risen after the budget shortfalls of countries including Greece swelled over the past two years. The U.S. is facing an unprecedented $1.6 trillion budget deficit in the year ending Sept. 30, the government has forecast. President Barack Obama’s administration is proposing a $3.8 trillion budget for fiscal 2011 in an effort to spur an economic recovery.

So far concerns about the Euro zone’s ability to withstand the deteriorating finances of its member nations have outweighed the U.S.’s deficit woes, propping up the dollar and keeping long-term borrowing costs low. However, investors will eventually demand higher interest rates to lend to countries around the world that have accumulated debt, including the U.S. The IMF forecast in November was that gross U.S. borrowings will amount to the equivalent of 99.5 percent of annual economic output in 2011. The U.K.’s will reach 94.1 percent and Japan’s will spiral to 204.3 percent.

Some PIIGS might fly

The PIIGS appear to be the tip of the iceberg in terms of stretched government finances and potential default. With economic growth and inflation forecast to be lacklustre in the years ahead, default could become a reality for even those sovereign borrowers currently rated AAA.

However a narrow focus on fiscal policy can be misleading. Take the PIIGS for example. Despite the catchiness of the acronym, not all of the PIIGS are equal. Greece and Portugal are by far the weakest of the group when a more complete set of measure is used.

The gross national savings rates of these two countries – private and state combined – are at record lows: Greece a mere 7.2 per cent of gross domestic product, Portugal 10.2 per cent. By contrast, the average for the euro area is about 20 per cent. Ireland and Spain, at 17 and 19 per cent, are much closer to the euro area average than to Greece and Portugal. This implies that Spain and Ireland will be able to finance government deficits from their national savings now that housing investment has crashed and no longer absorbs such a large chunk of savings. Greece and Portugal are unique in their much greater reliance on foreign capital.

Gross savings show the domestic resources (cash flows) available to finance domestic investment and consumption (wear and tear) of capital. With such low gross savings it is not surprising to find that neither Greece nor Portugal have been able to finance even a minimum level of net investment from domestic sources. Greece is unique in the Eurozone in that its net national savings – after adjusting for capital consumption – have been negative for almost a decade, reaching minus 5.1 per cent of GDP in 2008 (only Portugal did worse). By contrast, the euro area average is (plus) 6 per cent of GDP.

A harsh austerity budget that was introduced by Ireland in December and a (less plausible) plan adopted by Spain this year further bolsters the case for these countries versus their weaker peers. The cost of insuring Irish debt in the credit default swap market is now well down from its heights last year - around 150 basis points from 400 last year, meaning it would now cost 150,000 euro to protect 10 million Euros of five-year debt. The cost of insuring Spanish debt is around 162 basis points. In contrast Greek CDS prices remain high, despite falling in the last week to 356 from a high of 428 as the EU declared support for Greek reforms. CDS’s on Portuguese sovereign debt hit a record high of 216 basis points on 25th February.

Conclusions

While a huge, and growing, stock of national debt can be a cause for concern, fundamental investors will theoretically differentiate between those countries that have the resources and growth prospects to manage their burden down over time, and those that don’t. Similar to a corporate, a country’s ability to sustain high debt levels is dependent on the strength of its balance sheets before taking on the debt and also on its growth prospects. The track-record of revenue generation / collection and ability to manage their costs should also be taken into consideration.

However there is now a palpable nervousness when it comes to sovereign debt in the rich world. While the focus is currently on the PIIGS, large economies like the UK are also in what looks like deep trouble. By some estimates the UK government would have had a £200bn funding hole last year if it were not for “Quantitative Easing” purchases made by the Bank of England.  

While fundamental factors will drive the market in the longer-term, speculation – driven by fear or greed – drives it in the short-term. There is a lot of money to be made by speculating correctly against a sovereign default or downgrade (the strategy is to sell the debt or buy the CDS’s) and, as the ERM crisis showed in the early 1990's, and the East Asia crisis reminded us again a few years later, the path of international speculation rarely abates before every stone has been upturned. Unless there is decisive action by the EU to protect the PIIGS (these countries do not have a convincing track-record of fixing their own finances) we would expect at least Greece or Portugal (and potentially the other members of the group) to be forced into the arms of the IMF during the course of 2010. A humiliating rescue of a large economy (think UK) could well then be on the cards as well.   

----------------------------------------------------------------------------------

----------------------------------------------------------------------------------