Quantum Pranx


A Primer on Sovereign Debt

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by Arnold Bock
Originally posted May 19 2010


‘SOVEREIGN DEBT’ WAS A PHRASE ONLY FOUND IN THE ARCANE PROSE of economists writing in academic journals until relatively recently. Since the 2008 near death experience of many large banks, internet blogs carried commentary on the subject, but only very recently has the mainstream media tuned into the issue of sovereign debt. Quite simply, they could not ignore the omnipresent financial clouds any longer.

What is ‘Sovereign’ Debt?
In its simplest form, ‘ sovereign’ debt means ‘government’ debt, the financial debt of a country. It usually also means the accumulated debts of government sub entities such as states, provinces, municipalities, agencies, boards and commissions for which the senior government is ultimately responsible.

While existing government debt is the problem for today, contingent liabilities for promises of future services to its citizens dramatically complicates the current debt problem.  Unfunded future liabilities are obligations which represent the one ton gorilla peering through the front window of many nations.

What does Debt ‘Default’ Mean?
‘Default’ is a word similar to the word ‘bankrupt’ when referring to the inability of a private individual, business or institution which fails to meet its financial obligations. When debt is unable to be repaid, a formal declaration of this fact triggers a bankruptcy in a court of law. In the case of government, the inability to pay its accumulated debt from past spending, because it can’t raise adequate taxes or borrow additional funds means that government has become insolvent and thus forces a formal default on its debt.

Which Countries are Likely to Default on their Debt?
Daily revelations about the debt travails of Greece has trained the debt spotlight on other nations which are infected by a similar set of debilitating financial symptoms. Portugal, Ireland, Italy and Spain have boarded Greece’s sinking ship. These PIIGS are increasingly characterized as merely the frontrunners in a European marathon which could easily involve many more nations before long. But these five Euro member nations are only a small part of the sixteen Euro countries which are shackled by the constraints of a single currency. While Germany, Holland and a few other countries seem financially sound, many other members aren’t so well endowed.

To the Euro club can be added many other countries belonging to the larger European Union economic zone as well as select former Soviet satellite nations of Eastern Europe. More surprisingly still is how vulnerable certain very large first world economies have become. While it seems implausible, the United Kingdom, Japan and the United States are also rapidly attaining the unflattering attributes of the PIIGS, which means they too could be snared into the debt and default trap before it snaps shut!

What Makes Countries Susceptible to Debt Default?
Too much debt, but what is too much?  Annual deficits exceed 3% of the Gross Domestic Product is the standard the European Central Bank sets for its 16 ‘Euro’ member countries. 25 of 27 European nations are currently running annual deficits in excess of 3% of GDP. Ireland is at 14.3 %, France stands at 8% and Germany is at 6%. Greece stands at 12.5% of GDP. What this means is that government spending continues to escalate rapidly while their economies, upon which taxes are levied, are far less robust.

Debt accumulated from excessive spending in previous years is the cause of the looming financial crises. Economists Reinhart and Rogoff recently published comprehensive new research covering two hundred years of economic history which concluded that countries which reached debt levels of 90% of their GDP, rapidly descended into the flames of default hell. Many of the nations noted above are already close to this level of debt while others are turbo charging toward the 90% precipice of no return.

Given that current interest rates are at multigenerational lows, it seems entirely plausible that when interest rates start rising, the burden of higher interest rates on the bonds issued to secure additional borrowed funds, will become virtually unserviceable. If interest rates were to double from their current 3% levels on 10 year maturing bonds or double from the current 5% on 30 year bonds, most of these nations would very quickly reach the brink of default.

What are the Common Characteristics of Debt Default Candidates?
With the exception of Japan and the United States, all other default candidates are European. Many have advanced first world economies with high standards of living.  Most share political traditions and values whereby the welfare state ensures high living standards and guarantees protection and security against most of life’s challenges for their citizens.  Cradle to grave security requires ever higher levels of savings and investments which result in wealth generation and serves as a growing tax base sufficient to deliver on promises of current and future benefits, especially with the universal demographic of rapidly aging populations.

Virtually all countries subject to concerns about default show shortfalls in economic growth resulting in anaemic tax revenues requiring more credit and borrowing in order to compensate. Now that credit is either tightening or isn’t available and interest rates are rising again, this game of spend and borrow is about to end.

Can Debt Default be Avoided?
We are all faced with a daily deluge of metaphors by virtue of media coverage of the evolving financial carnage in Greece. “Dominos’, ‘Deck of Cards’, ‘Greek Contagion’, ‘Greece is the Precedent’ and ever more alarming and inventive terms.

We might remember the alarm we experienced less than 2 years ago when the largest investment banks seemed to be taking the entire world into a financial abyss. Over US $700 Billion was allocated immediately by the U.S. Congress to the Treasury Secretary for whatever mitigation measures were thought necessary. The Federal Reserve Board followed with many other exceedingly inventive measures costing US $Trillions of borrowed taxpayer dollars designed to lubricate creaky financial joints. This was government bailing out private institutions in the financial sector.

What happens, however, when governments themselves require emergency financial assistance? Greece represents only 2.5 percent [%] of the Euro club GDP economy, yet it has taken weeks to arrange US $140 Billion of assistance. What happens when countries with much larger economies and needs ask for assistance? The International Monetary Fund is making itself visible, but after the recent levy on member nations, they have only managed to bring their kitty from US $50 to $500 Billion. Spain, Italy or the UK could mop that amount up in short order. Then what?  Financially broken nations will be funding other financially broken nations. That is what the almost US $1 Trillion joint Euro/EU/IMF hurried announcement of Sunday May 8th represents. Does that seem like a workable plan? What happens when the banks who are creditors of these nations line up for assistance again, as they did in late 2008? Who bails them out this time when their own governments are broke?

A cynic might even suggest that sovereign debt bailouts are not primarily designed to assist nations nearing default. Rather financial assistance to nations simply allows them to pay their obligations to their foreign bank creditors who hold the bonds of the nations nearing default. In other words, collective efforts from the likes of the French, German, British, Spanish governments and others, is merely an elaborate ruse to keep their own banks solvent from the impending default of other nations.

The staid and highly regarded Bank of International Settlements based in Switzerland recently issued a sobering report in which it stated the need for “drastic measures…to check the rapid growth of current and future liabilities and reduce the adverse consequences of long term growth (of debt) and monetary instability.”  It went on to note that there is currently over US $600 Trillion of global financial Derivatives Debt…which is 10X annual global GDP.

What Does the Future Hold?
The magnitude of current private and government debt, coupled with massive unfunded contingent liabilities for promises of future services to their citizens, is simply impossible for many nations to fund. Massive inflation in the money supply will become the preferred vehicle to deflect the default monster, but it will result in vastly devalued currencies and price inflation as a prelude to default. Their objective is to buy time to stave off the inevitability of default. Buying time might also allow the tooth fairy time to arrive with a magic solution.

Stand by for a daily diet of social unrest caused by persons whose comfortable lifestyle and elevated standard of living is about to disintegrate before their eyes.

Protect yourself with precious metals investments. Gold and silver in the form of bullion or mining company shares will give you peace of mind. They are ‘real money’ and will be your safe haven during the very financially troubled and volatile period ahead. Further complement such investments with other commodities such as base metals, oil and gas and agricultural grains – all of which are investments which will shield you from inflation and currency devaluations but steer clear of fixed interest rate investments.

Arnold Bock www.FinancialArticleSummariesToday.com

Written by aurick

27/05/2010 at 10:46 am

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