Tuesday, 11 May 2010

FT Comment: This is not the way to solve the eurozone debt crisis - by David Roche

The aim of the emergency European Union financial stabilisation package was to create "shock and awe" in financial markets. It is designed to convince markets that they cannot win in forcing any eurozone state into defaulting on its debt.

Initially, markets may be wowed by the size of the package. But the size just means that more debt has been added to a problem that is about too much debt. EU governments and the European Central Bank are now obliged to guarantee or buy the sovereign debt of other members as a solution to the eurozone's debt crisis. But the solution to a hangover is not more alcohol.

The shock of this package will eventually give way to less awe. As all the AAA-rated nations in Europe have 70-80 per cent of gross domestic product public debt ratios already - not far behind the "junk bond" states (and worse than Spain), we reckon the market will soon wake up to the fact that this deal is a form of contagion by official action.

This package is not the circuit-breaker to end the crisis because it involves the creation of more sovereign debt to solve the problem of too much. It is a story that we have outlined for the whole of the Organisation for Economic Co-operation and Development.

As we explained in our book, Sovereign DisCredit!, the world is facing a sovereign debt crisis that will squeeze economic growth and possibly deliver a series of debt default events down the road. Sovereign debt issuance is sucking up 25 per cent of available world savings and that will squeeze the ability of the private sector to invest in productive opportunities. And there is a wide body of empirical research from the IMF, the BIS and the work of Carmen Reinhart and Ken Rogoff that suggests when sovereign debt hits these sorts of levels in so many large countries, it curbs long-term economic growth well below trend and could lead to debt defaults.

The EMU crisis is a harbinger for the future elsewhere. Average sovereign debt in the eurozone will be about 85 per cent this year and the eurozone will run an average budget deficit of about 6.5 per cent in 2010. That's bad enough. But it is lower than in the UK, the US and Japan. UK sovereign debt to GDP will surpass that of the eurozone average by 2011, as will the US, while Japan's is more than double. The US and UK budget deficits will be in double digits this year and probably next.

What investors must focus on is the conditionality of the loans and guarantees. If the profligate andhigh-debt governments of Greece, Portugal, Spain, Ireland (and perhaps even Italy and Belgium down the road) can get away with soft conditions for getting EMU financing, the euro will suffer for some time. So will all sovereign debt in the eurozone.

It certainly does not augur well that the ECB has been browbeaten into buying sovereign debt to help the junk bond status of some EMU governments. This can only debase the euro down the road and introduce ECBsponsored moral hazard.

The ECB move is an earthquake that marks a definitive divorce of ECB policy from all Bundesbank best practice. The bank is directly intervening in sovereign bond markets to distort the price of risk in order to finance the budget deficits of profligate countries. In that sense, bond prices will no longer reflect sovereign risk.

However, if the fiscal terms for the new facilities are tough, then the main issue is unchanged: namely, can these countries deliver fiscal austerity without restructuring their debt? That depends on the Germans ensuring that any terms for financing will be kept to.

Germany has reluctantly had to accept this emergency package. Germany managed to avoid a limitless guarantee, regardless of the costs and got external support from the IMF as part of the deal, rather than relying on just European funds, as the other eurozone member states had argued.

There were some modest new belt-tightening moves from some of the countries affected by contagion yesterday, but there is much further to go. So, in effect, all this extra debt and funding has been offered on good faith only. Berlin had to accept an increase in the existing ceiling for issuing eurobonds, something the Germans have always been against.

But the Germans will insist that any funds handed out to profligate EMU states must be on the basis of conditions agreed with the IMF and the EU Commission. Europe's fiscal war is only just beginning.

The real worry is that the eurozone debt crisis may seem like a tea party if the contagion spreads to the US, the UK and Japan. The UK has no effective government in prospect that can start to deal with its fiscal crisis, while the Japanese and US governments are in denial about the extent of their debt burden. Tighten your seat belts.

David Roche is president and global strategist at Independent Strategy

Published: May 11 2010

Monday, 10 May 2010

David Roche comments on Sovereign Debt on the BBC

Hear David Roche on the BBC Business Daily Podcast - His comments start after 6:45mins

BBC Podcast - Business Daily - 10 May 2010

Friday, 7 May 2010

Early Warning on Sovereign Debt Crisis - in FT article (31/03/2010)

Watch out for sovereign debt black holes
By David Roche and Bob McKee

Published: March 31, 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. It 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 gross domestic product 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, sovereign debt in Organisation for Economic Co-operation and Development countries 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 big 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 them to reflect their true nature as risky assets. 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.

David Roche is president and global strategist at Independent Strategy. This piece was co-authored by Bob McKee, economist at Independent Strategy. Both are authors of ‘Sovereign Discredit!’, to be published in April

Sovereign DisCredit! featured in FT comment article

Greece a bad omen for others in debt


By Edward Chancellor

published: May 2, 2010


The Eurosceptics have long argued that a currency union was inappropriate for Europe. However, Greece’s problems are not merely to do with the single currency. Rather, they are the result of national profligacy. Other governments have also over-indulged themselves. If the current economic recovery falters, sovereign debt crises are likely to break out beyond the borders of Europe.

The eurozone’s “one-size-fits-all” interest rate contributed to credit bubbles in the periphery. It also led to higher relative inflation, which has left countries like Greece, Portugal and Spain uncompetitive. With the traditional escape route of currency devaluation no longer available, these countries face severe deflationary pressures. Given such dire circumstances, it is small wonder the credit markets have lost confidence.

Yet it is possible that confidence in Greek finances would have collapsed even had the country never joined the eurozone. The key features of sovereign credit vulnerability are laid out in a timely new book, Sovereign DisCredit by David Roche and Bob McKee of Independent Strategy.

The single most important indicator of credit weakness is the national savings rate. Greeks are among the world’s leading spendthrifts with a net savings rate of around -7 per cent of GDP, according to Tim Lee of Pi Economics. Japan, by contrast, has been able to finance the huge expansion of its national debt over the past two decades thanks to its traditionally high savings rate. However, as its population ages, Japanese household savings are set to turn negative. Both the US and UK also have negative net savings rates.

Countries with low savings tend to grow more slowly and depend on external sources to fund fiscal deficits. In good times, governments have little trouble finding the money. Yet foreign creditors are more skittish than domestic ones; they take fright easily and during times of contagion are liable to force up interest rates, creating a debt spiral. This is what is happening to Greece where roughly 70 per cent of the national debt is held by foreigners.

The stock of outstanding government debt relative to GDP is another important measure of sovereign credit standing. Research by economists Carmen Reinhart and Ken Rogoff suggests that when the government debt burden becomes larger than 90 per cent of GDP, economic growth tends to slow, reducing the tax revenues needed to repay the loans. Greece’s government debt to GDP ratio is forecast to reach a 135 per cent by 2011. Yet it is not the worst culprit. Japan’s government debt is set to climb to 227 per cent of GDP by the end of next year.

The national debts of Britain and the US are also forecast to exceed the 90 per cent of GDP threshold by 2011. With their low domestic savings rates, the US and Britain depend on external financing. If foreigners were to lose confidence in either US or UK government finances, they would also demand higher interest rates.

The IMF has calculated the level of fiscal frugality needed for countries to bring their government debt levels down to a sustainable 60 per cent of GDP. According to the Fund’s calculation, the US would have to run a budget surplus prior to financing charges of 4.5 per cent of GDP a year for 15 consecutive years to bring the national debt down to an appropriate level. Japan would have to run a fiscal surplus of some 15 per cent of GDP for 15 years to reach the same target.
Rapid growth in government indebtedness is a further indicator of sovereign vulnerability. Ms Reinhart and Mr Rogoff observe that sovereign defaults normally occur after a frenzied run-up in debt. The average increase in debt in the four years prior to a sovereign default has been 40 per cent. By coincidence, Greek debt is forecast to rise by exactly this amount between 2007 and 2011. The national debts of the UK and Japan will climb by 44 per cent over the same period.

Quantitative indicators of sovereign credit vulnerability do not tell the whole story. Countries with bloated government sectors and cultures of entitlement, such as Greece, are more likely to default. There is an alternative. History suggests that when governments raise taxes and cut spending they are less likely to default.

Most governments, however, will follow the path of least political resistance. This will mean more spending and continuing fiscal deficits. Ms Reinhart and Mr Rogoff find that the cycle of sovereign defaults tends to pick up a few years after banking crises. Given the severity of the global credit crunch and the weak state of government finances in most advanced economies, it is unlikely that future sovereign debt crises will be confined to the shores of the Mediterranean.

Edward Chancellor is a member of GMO’s asset allocation team

Sovereign Crisis Contagion

In engineering there is a stress point when a structure will start to vibrate at what is called its “natural frequency” (think of a bicycle frame at speed). Left to its own devices, natural frequency vibrations will increase exponentially until the structure crashes. Have we reached this point of natural frequency for the euro?


The argument in favour is that, at current yields, there are few natural buyers for the sovereign bonds of EMU states that account for around 25% of Eurozone GDP. Venerable pension institutions and life insurance companies have bought these bonds by the truckload for 50 years on the understanding that their risk in doing so was only interest-rate volatility. Now the risk has been magnified by concerns for creditworthiness or solvency. So the pension fund and life insurance investors have become natural sellers of at least part of their substantial sovereign bond portfolios because the risk category has changed and no longer matches the institutions’ liability profile.

The arithmetic is pretty compelling. The countries in the ‘contagion area’ of the Eurozone (namely Spain, Portugal, Greece, Ireland and unexpectedly, Belgium) account for about one-fifth of Eurozone GDP. And their sovereign debt accounts for about the same ratio (Figure 2).

However, if pension funds and other investors were overweighted in their portfolios towards contagion area bonds in the hunt for higher yields, they would have around 30% of their fixed income assets in these sovereign bonds. Also, while the Eurozone average primary budget deficit is 3.6% of GDP in 2010, the contagion area is running a 6% of GDP deficit. So the repricing of sovereign bonds to reflect credit risk rather than just interest-rate risk makes these institutions massive natural sellers of 30% of Eurozone sovereign debt.

As  pointed out in Sovereign DisCredit!, when sovereign bonds lose their risk-free status, it’s a financial earthquake because so many other assets get repriced as a consequence. That is why contagion will quickly embrace other asset categories in the credit space and beyond it — such as equities and commodities. The same logic also indicates how the pain of sovereign repricing will be distributed beyond the banking sector to pension funds and life insurance companies if defaults or debt restructuring become the order of the day.

For the moment, however, the pressing issue is that, deprived of their constituency of long-term investors, many weaker Eurozone states cannot fund themselves. And there will be a massive overhang of their bonds to be sold should things get better, as they inevitably will. This is the cascade effect of asset repricing once sovereign debt is no longer perceived as risk-free.

Crisis contagion can happen not only between states but also within them. It can spread from a country’s sovereign debt to its other forms of foreign liability. Take Spain as an example. According to IMF and BIS data, foreign ownership of Spain’s sovereign debt is the equivalent to 31% of GDP. But add in private sector foreign debt (generously excluding intercompany lending from abroad) and the total jumps to 142% (Figure 3). For how long would the Spanish private sector’s access to foreign credit survive a sovereign debt crisis in the country?

Belgium - the next shoe to drop in the Sovereign Debt Crisis

ft.com/alphaville has a excerpt of Independent Strategy's report on the Sovereign Debt crisis spreading to Belgium:

The Beginning of the Endgame for Belgium

Friday, 30 April 2010

Sovereign DisCredit now available!!

Sovereign Discredit is now available from Lulu publishing.