Give or take, there are 196 nations in the world. The majority are indebted.
With the exception of some oil rich states that are actually paying down debt, most are accumulating more public debt.
So with every passing day nations add more tinder to the yet-to-be-ignited sovereign debt bonfire.
In 2008 it was the banks that faltered. Too much debt backed by lousy assets led to the GFC. The respective governments of the US, Europe, UK and even Australia stood behind their banks to restore confidence in the financial system.
Sometime in the next one or two years there is a high probability of a sovereign default (perhaps one that’s even too big to bail out). What happens then?
Who Will Stand Behind the Faltering Sovereign Nation?
After attending a seminar on sovereign risk held earlier this year in Basel, Jaime Caruana, General Manager, Bank for International Settlements, said:
‘I personally came away with an even stronger impression of the potentially dire implications for financial markets if sovereign borrowers cannot put their finances back on a stable medium-term footing. The macroeconomic arguments for fiscal consolidation are compelling: with populations growing older and the challenge of making good on open-ended promises of health and pension support, this is no time to be running up debts to risky levels.
‘Ominous too are the financial stability implications of sovereigns losing their all but risk-free status. As they do so, foreign investors unload their sovereign bond holdings onto domestic investors.‘
Losing their all but risk-free status? Who’s he kidding? The current ‘barely there’ interest rates have seen government bonds jokingly referred to as ‘return-free risk’.
When the joke morphs into something far more serious, it will unleash the destructive forces of the markets.
Central bankers think they can control the markets. For years the market has responded to the regular diet of dollar bills and ZIRP. Then suddenly something happens out of nowhere and without warning and the market turns viciously on investors.
As quickly as the disruption starts, it ends. The market is still there, but not so the investors who didn’t see the disruption coming.
Eventually, this disruption will happen on a bigger-than-ever scale and the victims will be the governments and central banks.
Why Will This Eventually Happen?
There are many nations with varying degrees of debt to GDP. In addition to existing debt levels, there are those running annual budget deficits to fund promises made in the good times.
Think of existing public debt levels as a series of sand piles – with some piles higher than others. Now imagine more grains of sand (deficit spending) pouring onto the existing piles. Eventually one or more sand piles collapse because the structure can’t cope with more weight.
Each sand pile is unique. One that is high and getting higher (Japan) can remain upright while a smaller pile (Greece) collapses.
As Caruana warns:
‘With populations growing older and the challenge of making good on open-ended promises of health and pension support, this is no time to be running up debts to risky levels.‘
Caruana’s statement acknowledges the obvious. Yet no politician is brave or stupid enough to confront the public with this reality. In the midst of an election campaign all you get is more ‘pork barreling’.
Given that those with the ability to reverse the spending and pay down debt have absolutely no intention or clue on how to do it, it will be up to the markets to deliver the message to the electorate.
Sadly the markets only act when it’s far too late to prevent inflicting severe pain on the economy – look at the unemployment rates and pension cuts in southern Europe.
In the interim governments are happy for central bankers to paper over the cracks and pretend all will be right with the world.
Perhaps the history and economic books are about to be completely re-written on how an exercise in excessive money printing ends. Perhaps a handful of central bankers are omnipotent over markets. Perhaps governments can deliver on an expanding list of promises to a growing population of retirees.
Or perhaps, bond markets awaken from their slumber and re-price the risk inherent in the debt issued by insolvent governments.
Don’t forget there have been numerous sovereign defaults over the centuries. The sand piles of debt have washed away and the government gets to start afresh. However, it has financially ruined the investors in those sand piles.
Right now it’s easy for investors to think governments and central banks have tamed the market. But history shows no one can tame the market without it leading to unintended consequences…these consequences just haven’t appeared yet.
Personally I prefer to sit behind the safety fence in cash. It’s boring as hell but patience has its own rewards.
Editor, Gowdie Family Wealth
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