Thursday 21 July 2011

Nature of sovereign debt as an asset challenged by Eurozone debt crisis

The debt crisis in Europe continues to stoke investor fears and weigh on world markets. The following update is based on the views of leading BlackRock investment professionals: Robert Fairbairn, Head of Global Client Group; Ewen Cameron Watt, Chief Investment Strategist of the BlackRock Investment Institute; Scott Thiel, Deputy Chief Investment Officer of Fixed Income; Russ Koesterich, iShares Global Chief Investment Strategist; Peter Fisher, Head of Fixed Income Portfolio Management; and Nigel Bolton, Head of EMEA Equity Style Diversified Team.

Update on the European debt crisis

What had been debt turmoil contained to the smaller European peripheral countries, in particular Greece, Ireland and Portugal, has escalated to contagion with the potential to engulf larger nations such as Italy and Spain. While the first phase of the sovereign debt crisis developed over the past couple of years, the most recent events have been sparked by the International Monetary Fund's scheduled review of Greece and the resulting discussion of a debt extension and rollovers. This caused rating agencies to downgrade the debt of Greece, Ireland and Portugal, resulting in a subsequent decline in the value of those bonds and elevating the risks to the entire European banking system.

Because European banks provide the lion's share of credit in the region — as opposed to the situation in the United States, which relies on the capital markets for credit — any impairment to European bank balance sheets threatens to derail the European banking system. Widespread impairment across bank balance sheets is a slow process. However, with the decline in value of European sovereign debt, which serves as the reserve asset of European banks, the ability of banks to lend becomes impaired, with significant negative consequences.

US debt ceiling hanging in the balance

At the same time, in the United States, concern that US sovereign debt is becoming a risky asset has increased, with protracted political wrangling between the President and Congress over raising the debt ceiling. This dynamic has triggered warnings by rating agencies Moody's and S&P regarding potential downgrades of the US as an issuer, a seemingly inconceivable and disastrous outcome.

In our view, allowing any measure of US debt default would be nothing short of an act of lunacy by US politicians. Fortunately, some very concrete proposals have been introduced into the debt ceiling discussions, implying that legislators are serious about addressing this issue. Default is highly unlikely.

The risks of increasing European contagion

Uncertainty, volatility and illiquidity are the immediate risks for investors. If indeed Greece does default, the risks to Ireland and Portugal also increase greatly, potentially creating a domino effect. At the same time, debt-to-GDP levels in Italy and Spain, in combination with slowing economic growth trends and high unemployment, are particularly troubling.

Spain, with 15% of the sovereign funding market, and Italy, the Eurozone's third-largest economy and representing 25% of the sovereign funding market, have both been under mounting pressure related to fears about the fate of the banking sector. Contagion in Spain and Italy would have extreme consequences for the Eurozone and the European Central Bank (ECB). While the European Union (EU), IMF and ECB can help the financing needs of the smaller countries, they could not support almost half of the European bond market.

A solution requires political agreement

Given the political nature of any long-term solution, which would require the backing of all 17 Eurozone member states, there is a great deal of uncertainty as to the eventual outcome and any agreement will take time. However, with EU bank stress tests and a meeting of European leaders currently taking place, events continue to move fast.

In addition, any such solution will need to be formed under the political constraints of the upcoming European elections, which are slated to occur over the next 24 months, as well as under the more immediate pressure of ?365 billion in debt coming due in the short term. A large question mark regarding the solution and outcome focuses on the current and future involvement of the private sector, and clarity on the size of exposure/losses would help to alleviate some investor uncertainty.

Other tricky issues relate to political recognition of writing down the liabilities of sovereign issuers and also writing down the assets of the holders such as banks and the ECB. Many politicians are reluctant to impose this on the banking system. The fiscal adjustments required in the peripheral countries are extremely large and they also create, along with banking credit difficulties, further risk of a negative feedback loop to growth. There also will be greater uncertainty about the most likely path for the reduction of fiscal deficits because of the strong link between economic growth and tax receipts.

The nature of sovereign debt as an asset is challenged by this crisis

Sovereign debt was until recent years a type of high powered money substitute. Banks used it as collateral for funding and regulated institutions hold significant amounts of sovereign bonds as regulatory capital. As a consequence of the financial crisis, fiscal revenues have fallen and government borrowing levels increased. In turn, this has made investors reassess sovereign debt as a riskier asset and less prepared to hold these assets if perceived risks increase.

Additionally, bond indices differ from equity indices in that they reward failure. That is, the more debt raised, the higher the weight of the issuer in an index and therefore the greater the risk that the issuer may be unable to meet their obligations if economic circumstances change. In contrast, equity indices generally reward success with growing companies taking a larger weight in indices. (BlackRock)

Comments from Michael Ruppert:

The $1 quadrillion-plus derivatives bubble is imploding and it can't be stopped. This is an essential step in changing the way money works. Before anything new can be built the old system must come down. It has to hit a bottom. We ain't there yet, but this is a headline that signals true impending collapse and demise of the infinite-growth dinosaur.  What will come after is what we all fight for now. -- MCR

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