Watch Out For Sovereign Black Holes

¹²Watch Out For Sovereign Black Holes In The Credit Universe

By David Roche, FT | 1 April 2010

Will The Next Step In The Credit Crisis Centre On Sovereign Debt? And What Would That Mean?

My co-author[?] and I argue that high levels of sovereign debt will, at best, mean significantly below-trend economic growth over the rest of this decade. At worst, there will be a series of sovereign debt defaults that will ricochet through some leading economies and plunge the global economy back into recession. Sovereign debt is normally deemed risk-free. It is the touchstone by which other "riskier" financial assets are priced.

Sovereign debt forms the core of low-risk portfolios destined to fund such real social needs as pensions and casualty and cataclysm insurance. It is the liquid asset that lies at the heart of current regulatory reforms to oblige banks to hold sovereign debt in proportion to their exposure to "riskier" assets and potentially illiquid short-term funding. A repricing of sovereign debt as 'dangerous' debt would be an earthquake for financial markets.

It would blow a hole in the balance sheets of previously 'safe' financial institutions. That would be a new chapter in the credit crisis. But it would be a logical progression.

During the financial crisis, far from being a substitute for private sector deleveraging, which is only at an incipient stage, the state has piled on its own layers of debt. Leverage has never been higher. Government dissaving in the form of structural primary budget deficits equivalent to 9-10 per cent of GDP has been added to already inadequate levels of household savings. If over-indebtedness and lack of thrift were the causes of the credit crisis, the policy prescription has been to give the dope fiend more dope.

By the end of this year, OECD sovereign debt will have exploded by nearly 70 per cent from 44 per cent of GDP in 2006 to 71 per cent. According to the Bank of International Settlements, it would take fiscal tightening of 8-10 per cent of GDP in the US, the UK and Japan every year for the next five years to return debt levels to where they were in 2007. Some say that a temporary increase in sovereign debt always happens after a credit crisis. Research by US economists Carmen Reinhart and Kenneth Rogoff shows that sovereign debt usually rises by an average of 85 per cent within three years of a financial crisis.

But this credit crisis is like no other. Our own calculations show that the budget deficits of crisis-struck countries now equal more than 25 per cent of global savings and 50 per cent of savings within the OECD. And the increase in debt ratios is on a different scale because it simultaneously affects all the big economies, not just an Argentina.

Studies by the IMF and by Reinhart and Rogoff also show that there exists a tipping point— when sovereign debt breaches 60-90 per cent of GDP— beyond which the impact of more state spending is to reduce growth and even to make the economy shrink. Sovereign debt is already (or is set to rise) above such a tipping point in the US, the UK and the eurozone. It is already more than twice that level in Japan. This means rich countries will lack a dynamic core to help them grow their way out of their debt spiral by boosting GDP. Indeed, if growth falls below the yields on their bonds, these countries will become sovereign black holes in the universe of credit, with uncontrollable upwardly spiralling debt levels.

It has been possible in the past for countries to run unsustainable fiscal arithmetic for lengthy periods. Italy did for eons. Japan has been at it for a decade. But to achieve that, a country must have high domestic savings that citizens want to keep at home in "safe" investments. The majority of government debt must be owned by domestic investors, not by foreigners.

And it needs a fat excess of gross domestic savings over investment needs, which yields a current account surplus. This keeps the currency strong and makes low domestic returns look good relative to those of foreign assets. None of the major credit crisis-stricken states has any of these strengths today. Even Japan now has a household savings rate below the inadequate level of the US.

None can fund their debts and deficits domestically on a durable basis. They will all have to sate their appetite for funding at the same trough of international savings, which will reprice [their sovereign debt] to reflect their true nature as 'risky' assets [[as is currently happening to Greece: normxxx]]. This will happen as soon as central banks stop monetising government debt by buying their bonds and when domestic savers take fright.

Creating new sovereign borrowing to finance another thriftless consumer binge and more asset bubbles is no way to achieve sustainable growth. Unless immediately addressed, the excess of sovereign debt will be the next chapter in the credit crisis. Moreover, the creditor-of-last-resort, China, is showing decided misgivings about where it stashes its largesse. They may simply end up using all or most of it for buying their own domestic gold.

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Normxxx    
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