Sunday Musings: A Sovereign Debt Crisis

Forbes featured an interesting story by Nouriel Roubini titled “The Coming Sovereign Debt Crisis.” Here are some highlights:

In 2009, downgrades and debt auction failures in countries like the UK, Greece, Ireland and Spain were a stark reminder that unless advanced economies begin to put their fiscal houses in order, investors and rating agencies will likely turn from friends to foes. The severe recession, combined with a financial crisis during 2008-09, worsened the fiscal positions of developed countries due to stimulus spending, lower tax revenues and support to the financial sector.

In 2008 and 2009, the decisions by these governments to do “whatever it takes” to backstop their financial systems and keep their economies afloat soothed investor concerns. But if countries remain biased toward continuing with loose fiscal and monetary policies to support growth, rather than focusing on fiscal consolidation, investors will become increasingly concerned about fiscal sustainability and gradually move out of debt markets they have long considered “safe havens.”

Most central banks will withdraw liquidity starting in 2010, but government financing needs will remain high thereafter. Monetization and increased debt issuances by governments in the developed world will raise inflation expectations. These governments will have to offer higher real yields or investors will move to more attractive emerging markets.

The UK, Spain, Greece and Ireland will face sovereign risk pressures, especially if their fiscal imbalances are not addressed immediately. Some eurozone members are quickly approaching their debt sustainability limits as deleveraging through devaluation is not an option for these countries. Countries like Germany—whose fiscal imbalances have deteriorated largely due to the economic and financial downturn—might have a greater capacity to stabilize their debt ratio. The U.S. and Japan might be among the last to face investor aversion—the dollar is the global reserve currency and the U.S. has the deepest and most liquid debt markets, while Japan is a net creditor and largely finances its debt domestically. But investors will turn increasingly cautious even about these countries if the necessary fiscal reforms are delayed.

Developed economies will therefore need to begin fiscal consolidation as soon as 2011-12 by generating primary surpluses, which can be accomplished through a combination of gradual tax hikes and spending cuts. However, an aging population, a sluggish economic recovery and higher unemployment will keep governments’ entitlement spending high and revenues subdued. These factors might also make tax hikes politically challenging. Fiscal consolidation efforts might not be strong until the bond vigilantes signal shifting to safer assets.

[Emphasis added]

You can probably add a few South American countries, such as Venezuela, to the list of those facing sovereign risk pressures. While I agree that loose fiscal policies need to come to an end, I just don’t see it happen anytime soon.

The more likely consequence will be a financial blow up someplace in the world, which may unravel the current stock market rally. This has been my recurring theme for a long time not for the reason of me being negative, but simply being realistic.

We are living in an interconnected, changing world were no major catastrophic financial event remains localized. Everybody is connected with everybody else, and we are all affected by each other’s actions to varying degrees.

My point in these discussions is always the same. Don’t become complacent with your investments. Know your exit strategy and follow through executing your trailing sell stops whenever they are triggered.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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