NEW CONTAGION: GDC TO REPLACE GFC

Written on the 17 May 2010

NEW CONTAGION: GDC TO REPLACE GFC

THE significant volatility on the international equities market demonstrates a high level of anxiety surrounding the current ‘Government Debt Crisis’ (GDC).

With this playing out, we are seeing the GDC dramatically overshadow the recent encouraging corporate earnings reported by businesses in the United States, bringing back bad memories of the volatile market trends of late 2007 and 2008.

So while the ugly head of the Global Financial Crisis (GFC) reared itself in 2007, it did not properly crystallise until 2008 as people found it extremely difficult to price the underlying risk weaving its way through the market.

It was only once this risk ultimately made its way through the corporate system to those entities actually insuring it, such as American International Group (AIG ) that it became quantifiable, with the 2008 bail out package for AIG (the largest insurer of the credit defaults and credit derivatives) totalling US $85 billion.

The same can be said about the current GDC as it currently weaves its way through various governments (having passed through Dubai now on to Greece, Spain, Iceland, Ireland, Portugal and potentially the US).

Understandably, many people are scratching their heads trying to work out if governments (particularly, the European and US ) can absorb and properly manage the significant amount of debt that once sat within the private sector.

The current sell down suggests that people do not think the governments can properly manage their debt portfolio, or at the very least, are still trying to quantify the risk associated with the GDC.

When it comes to understanding how governments can absorb and manage debt, and make decisions about when to take on debt, there are a number of additional complicating factors that don’t exist in the private sector.

It is it crucial to properly understand the interplay between the government itself, treasury departments (which continue to print money), the federal deficit and debt. Bringing it back to basics, a federal deficit occurs when the spending of a government is greater than the revenue received. While the federal debt is the total amount of debt owed.

Further, if treasury departments continually print money, more people will spend it causing inflationary problems.

Let’s take the US as an example. Its current deficit is estimated to be around US $1.5 trillion and forecast to be US $1.27 trillion next year, noting that currently the total debt owed by the US government is around US $12 trillion. In simple terms, the US is on a fiscally unsustainable path.

There is the potential for the current GDC to become another new contagion not too dissimilar to the one that spread during the GFCC. The GDC facing Greece is a prime example of this, and of how quickly it can spread.

The big challenge facing Greece is whether it can meet redemption obligations in the coming weeks, with the requirement to redeem 8.5 billion euros falling due on May 19.

As this date looms closer, the costs associated with any refinance of this debt obligation is increasing exponentially, with yields on two-year Greek government notes increasing 505 basis points to around 19 per cent while the yield on 10 year Greek bonds moving to 11.24 per cent.

Greece’s problem has been compounded not only because Germany has indicated that it only wants to be a lender of last resort, but also because its been re-rated to ‘junk status’ (a signal that debt will be high risk and typically too risky for institutional investment). This re-rating has had a ripple affect throughout Europe, resulting in increased borrowing costs for countries from Italy to Portugal and Ireland.

Let’s be clear, the GD C is a new contagion capable of spreading throughout the world  unless it can be cured. The cure is cash and more deleveraging. If the GD C in Europe has you concerned, try to envisage the panic if the US government debt problem follows a similar course.

The symptoms are starting to show, with shifting spreads on US debt, and other subtle signs that US debt is becoming riskier. For example, in January, China was overtaken by Japan as the country that held the most US Treasury Bills.

If the credit rating of the US was jeopardised and down graded, we will see a far greater equities sell down to the one that occurred in September 2008. If this happens no one will be immune, including the Queensland resources industry which came through the GFC relatively unscathed.


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