January 2010

Sovereign debt concerns

In the final weeks of 2009, the debt crisis, which had hitherto been centred at the banking and corporate levels, began to assume an altogether different dimension. Revelations of financial difficulties in Dubai were compounded by news of an actual credit downgrade for Greece and the threat of one for Spain, with the spotlight then moving to Ireland, Italy, Portugal and even the UK.

Since the financial crisis began in the autumn of 2008, governments have become increasingly indebted in their efforts to stabilise their economies. As a result, budget deficits have swollen to such an extent that badly impacted countries like Greece and Ireland, who do not have the option to devalue their respective currencies, may ultimately have to abandon the euro as their domestic currency unless they are effectively bailed out by the European Union or the International Monetary Fund intervenes. For lenders, the fear is that, if no decisive action is taken to address deficits of this magnitude, these nations may be unable to restore public finances, and, in the absence of guarantees from a higher authority, may thus be obliged to default on their debt repayments.

Crucial to developments going forward is the role of credit-rating agencies Moody’s, Standard and Poor’s and Fitch – the same agencies who were accused of contributing to the international debt crisis by seriously misleading investors about the creditworthiness of certain issuers, especially with regard to credit derivatives whose valuations later proved to be incalculable. The rating assigned by these agencies to any form of debt, whether corporate or sovereign, tends to impact borrowing costs i.e. lenders will require less assurance, in financial terms, from a highly-rated issuer than they would from a lowly-rated one. For countries desperate to raise much-needed funds, these extra borrowing costs only serve to exacerbate their predicament.

Contagion fears

Perhaps the worst-case scenario for the investment community would be a credit-rating downgrade for the US. This would send a shock wave through the entire credit market, as the effect of the increased borrowing costs for the world’s largest economy would presumably have an even greater adverse impact on borrowing costs for both companies and the emerging market economies. Although the US remains highly rated for now, the mere inference that a downgrade may be possible could deter potential lenders (the most recent US government bond auctions were poorly received).

Although hopes are high that the worst deficit offenders will be helped if matters deteriorate further, the prospect of sovereign debt default threatens to become a major concern for the markets in 2010 and should not be taken lightly.