Sovereign Debt — the Next Crisis Looming

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA

Last year, there were many downgrades of sovereign debt among developed economies and quite a few failed government debt auctions. It had happened in countries such as the U.K., Greece, Ireland. Harsh reminders that, until governments clean up their messy balance sheets, investors could not only turn their backs on them, but could also turn into vicious enemies.

How are central bankers to clean their countries’ balance sheets? And with what funds exactly? The Great Recession of 2008/2009 has deteriorated fiscal standings of developed countries, because they were forced to pump the proverbial mountain of money into global financial systems, cut taxes, and support the financial sector, even when saved banks didn’t deserve a redeemer.

To make matters worse, many developed economies already had serious structural financial problems, mainly because their fiscal policies were not well-thought through and because no one bothered with regulation and economic reforms during the boom era. However, now everything has changed. The economic recovery is very weak and slow. And, an aging population is only going to create more debt instead of help reduce it.

Ever since the first economic stimulus hit the veins of the U.S. financial system, I feared that the “whatever it takes” attitude would cost us more than we could pay. Granted, the Great Recession was severe and it ran deep. But backstopping it with trillions of dollars worldwide could soothe fearful masses only for so long. What is needed now is sound fiscal consolidation. Without it, a concept such as fiscal sustainability will go out the window.

Most central banks are expected to start shutting off their taps in the second part of 2010, which will also mean that governments will have to find ways to finance their needs. At this point, it is clear these financing needs will have to be very high. As developed governments focus on monetization and raising revenues through debt issuances, chances are inflation is likely to raise its ugly head, too. Unless higher real yields are offered, investors are likely to move to emerging markets, where higher returns could be less risky to obtain.

So, with higher yields and higher costs of debt, economic growth will likely be curtailed by the “crowding out” of consumer spending and investment, thus further limiting any government’s meaningful spending. Yet, unless government debt is perceived as a “safe haven,” it diminishes its face value and exponentially increased the risk of sovereign debt default.

In other words, if there is little faith in an economy, there is little faith in that country’s government. If the government cannot increase revenues, other than by means of increasing taxes, that government is on its way to becoming a pariah among its peers. Once a pariah, the potential for sovereign debt default becomes tangible as a country faces sovereign bankruptcy pressures, much like Iceland, the U.K., Greece and Spain already have experienced.

As for the U.S., along with Japan, it might be among the last developed economies to face investor flight from the U.S. dollar and its government treasuries, but we’re hardly out of the woods. This is only because the U.S. has one of the most liquid debt markets in the world. But the moment the world realizes that the U.S. is delaying fiscal reforms, it will take this as a signal that the U.S. is not serious about its problems and will flee towards new safe havens, mostly within emerging market economies.

What is the remedy? Economists agree that developed economies need to figure out a way to consolidate their balance sheets by the end of this year. Then, in 2011-2012, they should start implementing their plans, focusing on fluffing their assets by a combination of gradually increasing taxes and reducing spending. These measures are likely to be met with resistance, but the days of popularity contests are over. To ensure fiscal reforms are implemented, stricter regulation might be the way to go.