The absence of a sovereign debt crisis between 2003 and 2008 was part of the historical cycle, not a new paradigm, writes Scott B MacDonald. Bond-biased investors should prepare for the inevitable return of the painful part of that cycle
Bank failures, company repayment problems and massive budget deficits in Iceland, Ireland, Dubai and Greece in 2009-2010 indicate that sovereign risk remains a factor in international markets. Indeed, the threat of a Greek default early this year rippled through the European Union, pushing worried investors to first re-examine their perceptions about the creditworthiness of Portugal, Spain and Italy and then take that same re-examination up to the world's most challenged debtors - the UK, Japan and the US.
For all of the finely-tuned quantitative models and armies of seasoned financial experts, the timing of events such as sovereign debt crises usually appear as a shock. There are often smug egos proclaiming that new risk-free paths to the future have been created - a point hammered home by Carmen Reinhart and Kenneth Rogoff's, This Time It Is Different: Eight Centuries of Financial Folly (2009). Their central thrust: "We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply. Unfortunately, a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off."
In many regards, that is where the global economy finds itself in 2010 - a place where it can tumble off the cliff of financial solvency in the form of major sovereign defaults.
The last three decades prior to 2003 witnessed an on/off pattern of debt build-up, followed by problems in repayments, often starting in the private sector (as with bank and corporation failures) and ending up on government balance sheets. This was certainly the case during the Asian contagion 1997-98 and Russia in 1998.
One of the last major sovereign defaults came in December 2001 when the Argentine government collapsed and ceased all debt repayments. From 2003 to 2008 the global economy was treated to a rare absence of major sovereign defaults or illiquidity events. This period enjoyed strong economic growth, a deepening of the globalisation process and a burst of cross-border financial transactions (pushed by financial innovations like the credit default swap).
Critical to the 2003-08 period was a relatively coordinated central bank effort to kill inflation (excepting Japan) and facilitate growth and stability. The global economy was defined by the easy flow of capital, ready access to international capital markets by an increasingly wider group of borrowers and extensive leverage. It appeared that sovereign debt crises were something of the past.
Despite claims that global financial managers have developed better risk management techniques and created international co-operation safeguarding against cross-border contagion, sovereign crises are resuming their natural place in economic life. It could even be suggested that there is a degree of cyclicality to large-scale sovereign debt crises, linked to debt unsustainability (too much debt incurred by public and private actors), illiquidity (a shortage of foreign exchange to repay debt) and macro-exchange rate risks (that is, a botched devaluation).
Returning to the norm?
Indeed, the historical norm is one of sovereign defaults. According to one study, from the end of the Napoleonic Wars and the rise of international lending in 1824 to 2003, 94 countries defaulted a total of 235 times. Serial defaulters like Uruguay, Mexico, and Costa Rica each defaulted eight times. Historical data indicates cycles. Research by Carmen Reinhart and later her book with Rogoff provide a picture of long periods where a high percentage of all countries are in a state of default or restructuring their debt. Along these lines, they identified five pronounced periods of debt default peaks (figure 1), to which we can now add the sixth - 2009-onwards.
Sovereign risk is back, and there is a likelihood that there will be more threatened defaults and inevitably, depending on the significance of the country, rescues. For many international policymakers, Iceland can default as its market significance at this stage is minor. Greece cannot be allowed to default, as it is a member of the EU and there are well-placed worries about contagion. More importantly, there is greater pressure on the major OECD economies to get their fiscal houses in order - no one wants to explore the impact of a default there. Germany's default in the 1930s marked the plunge into the credit abyss of what was then the world's third largest economy.
First and foremost, all of this means that the purchase of high-rated OECD sovereign debt must be seen in a new light. What might have been a ‘risk-free' purchase over the last few years is likely to be more risky now. This is certainly the case with the UK, considering the risk of a hung parliament in the 2010 elections and its messy fiscal situation. The same could be said for the US with the threat of gridlock in Congress; or for Japan, which faces elections to the upper house of the Diet in July.
A second factor for investors to consider is the impact of a large amount of sovereign issuance in global debt markets. Considering the substantial amount of sovereign debt needed for financing large budget deficits, there is a danger that other issuers could get crowded out. This could put financial companies, themselves with large refinancing needs, in competition for investors.
A third factor for investors is the issue of ratings. As many investors in monoline insurance firms will testify, triple-A ratings can quickly evaporate despite rating agency commentary that these are long-term ratings taking into consideration business cycles. Considering the rating agency penchant to be heavily reliant on quantitative models to determine risk, they clearly run their own risk of missing behavioural developments that can rapidly erode creditworthiness.
Consequently, the return of sovereign risk appears to be part of a broad historical cycle. For a brief period, there was a break in sovereign defaults but, as in the past, there is now a return to the norm. Although it should be apparent at all points in the credit cycle, it is more pertinent for buyers to beware - what may seem to be risk-free may represent future default risk. And the path ahead is likely to place a greater emphasis on sovereign risk.
Scott B MacDonald is the head of credit and economics research at Aladdin Capital Holdings, and co-author of ‘When Small Countries Crash' (forthcoming from Transaction Publishers).