News & Commentary

The Sovereign Debt Crisis 29 Jun 10

By James Dunn

Remember the carefree days of 2007, before the GFC hit? Back then, all that investors had to worry about was the risk of companies going bust. Then the GFC came along, and we learned that we had to worry about banks going bust.

Now it’s countries.

The European sovereign (government) debt crisis has raised the spectre of debt default by nations, which would not only cause political problems, but plunge the global banking system back into the chaos from which it was only recently thought to have been saved.

The epicentre of the crisis is the southern European belt of nations, in particular Greece – although its fellow Euro members Italy, Spain, Ireland and Portugal also display highly parlous public balance sheets.

In early May, with Greece seemingly on the brink of insolvency and markets hammering the other perceived Euro members such as Spain and Portugal, the viability of the Euro itself was under threat. But on the weekend of Europe Day – May 9 – the European Union (EU) bit the bullet, and with the assistance of the International Monetary Fund (IMF) created a massive €750 billion ($1.1 trillion) crisis fund, more than half of which consisted of loan guarantees.

The package helped to neutralise the markets’ fear of ‘contagion’ spreading from Greece’s diabolical state finances, but more importantly, appeared to have given the troubled southern European economies the time and breathing space to restructure their budgets and balance sheets.

In reality, the main EU economies, France and Germany, had no choice but to organise and contribute to the package, because French and German banks are among the biggest holders of Greek bonds. It was a case of bail out their European partner nation, or bail out their own banks.

To the markets, however, this is no longer solely about Greece – but about the cracking of the edifice of the Euro. It was one thing for Greece’s sovereign debt rating to be cut to non-investment-grade (or ‘junk’) but another for Portugal’s to be cut to AA- and Spain’s to AA. Spain’s downgrade presages another Greece-style bailout. These far more serious downgrades call into question the financial solidarity of the Euro itself.

The rules set out for membership of the European currency have fallen short of protecting individual EU countries from other nations’ debt levels. And Germany, which thought that it had locked in an assurance that any member country that got into fiscal difficulty was on its own – meaning that its taxpayers would never have to bail-out nations that did not work as hard as they did – faces the massive political pain of telling its citizens that they must work two extra years (to 60) so that the Greeks can be prevailed upon to extend their working lives by ten years to age 50.

In return, Greece had to begin the long and painful process of dismantling some of the untenable planks of its generous statist economy. A few small examples: Greek state workers receive 14 months’ pay for their 12 months of work; Greece has free healthcare; free education – including tertiary. But the party is over, because tax revenue no longer pays for all of these things – although the spectacle of deadly riots on the streets of Athens in May showed that not everyone accepts this fact.

Although world markets initially welcomed the EU/IMF support package, the subsequent credit rating downgrades for Spain and Portugal put paid to any thoughts that it had completely solved the problem. In reality, the sovereign debt crisis merely shows investors that the world still needs to ‘deleverage’ – to wean itself from debt.

The worry for investors is that it is not only Greece and its fellow European Union strugglers that show debt levels too high. The USA now has a budget deficit of 11 per cent** of GDP, which is not far short of Greece’s, at 13 per cent.* of GDP. The UK’s budget deficit this year is projected at 12 per cent* of GDP – and these are far bigger economies than Greece

Across the developed world, there is a pressing need to bring public balance sheets back under control. The spending austerity and tax-lifting programs needed to accomplish this will bring with them high unemployment and low economic growth – to say nothing of the social costs. But these programs need to be applied.

On top of US economic growth that looks like slowing in the second half of the year, it adds up to a world not as healthy – economically or fiscally – as investors might have hoped for at this time, a year ago. This puts more pressure on China and the emerging nations to deliver what growth there is – but weak economies in the US and Europe don’t help them sell exported goods there.

It is hardly surprising that after a global financial crisis the aftershock and political and fiscal pain continues to challenge the world’s economies. The new normal looks more like one where it is important for investors to have more realistic return expectations and pay attention to risk within their portfolio.

Data sources:
*UK and Greek figures sourced from Eurostat
**US figure sourced from the Congressional Budget Office (CBO).