A web of credit market risks

By Sheldon Dong, CFA, Vice President Fixed Income Strategy, TD Waterhouse Canada Inc.

Greece is front-and-centre of credit market woes.

Credit markets remain the epicentre of financial system risk and the heart of economic growth. Contrary to the disproportionate attention that the media place on equity markets, credit markets are vastly bigger in scale and are the lifeblood of every economy.

Credit markets are highly sensitive to perceived risks and should be one of the first places people should turn to when looking for signs of distress. Recovery from credit crises is rarely simple, or swift, as problems stem from having too much debt. Not paying debt causes financial system malaise, while reducing debt takes time.

There have been recent indications that a second wave of financial distress may be developing. In 2009, extraordinary coordinated efforts by governments helped rescue banks, the financial system and the global economy. In 2010, it appears that some governments are in need of rescue.

What is sovereign risk?

Sovereign risk is simply the risk of a country defaulting on its debt (issued to foreign investors). Sovereign defaults are not as uncommon as many investors seem to think.

More recently among larger nations, Argentina defaulted in 1982 and in 2001, while Russia defaulted in 1998. Just as profligate spending can overwhelm individuals, so can it overwhelm countries. After culling weak financial institutions last year, credit market vigilantes have shifted their focus this year towards weak governments. This is simply moving up on the food chain as countries have become even more bloated in debt through their efforts to bail out banks and to resuscitate economic growth.

Greece in the spotlight

The country in focus currently is Greece, a nation with a history of being a serial defaulter, with a default rate of roughly one out of every two years since it first gained independence in the 1830s¹. Credit markets are based on faith and trust, qualities that are difficult to earn and easily lost. Just as banks demand a good credit history when making loans to individuals, the bond market does the same for countries. Greece is being highlighted because it has been living way beyond its means and because it has a lot of debt coming due, which must be rolled over into new loans.

Greece’s external debt (to foreign investors) amounts to 170% of national income, its government budget deficit is almost 13% of its gross domestic product (GDP) and its debt-to-GDP ratio of 125% is the highest in the European Union.

Given past history, debt markets currently do not attach much credibility to Greece’s pledge to meet Europe’s target of cutting its budget deficit down to 3% (a requirement as a member of the Eurozone) in only three years. The implausibility of that task is based on the highly socialized nature of the state and previous lack of political will.

Higher borrowing costs

As a member of the Eurozone, Greece enjoyed more advantageous borrowing costs as lenders believed that it would adhere to the rules of membership and that there would be implicit backing by other nations within the Eurozone. Without that support, or facing possible euro expulsion, Greece’s cost of borrowing is moving higher to reflect lender concerns.

In the past, Greece could simply default on its debt or devalue its currency, with bond investors taking a loss in the restructuring process. However, a default appears to be something that must be avoided at almost all costs because of Greece’s potential impact on the euro currency.

Unlike the American dollar, which has been around for two centuries and enjoys the full faith and credit of the U.S., the euro is a recent innovation (11 years) backed by the Treaty of Lisbon. Faith and trust in the euro could be compromised if one of its members were allowed to default.

Policy risks

The Eurozone has a single monetary policy, yet every country — 16 members, currently — can set its own fiscal and tax policy. As a member, a peripheral country like Greece was able to borrow money at rates far lower than it could have on its own, based on assumptions of implicit support from Eurozone members. Not bailing out Greece at this time could pose significant systemic risks to the banking system, as Greek debt is held by many European banks, which are still recovering from the 2008 global financial crisis.

History is now being tested as the world waits to see how Greek citizens will react to being dictated to by Germany, or whether German taxpayers will be willing to further subsidize Greece living beyond its means.

If the Eurozone decides to cut Greece's loose for the good of the euro, will it prevent bond vigilantes from attacking the next weakest victims (Portugal, Spain, Italy and Ireland)? If more members are cut loose, will the euro be able to survive as a stable or viable currency?

A moral hazard

On the other hand, the implicit guarantee the European Union recently provided (moral support without financial details) to quell speculative fever may do more harm than good for the euro in the longer run.

Given the survival instincts of politicians, a bailout (or even existing promises to help) from the European Union creates a moral hazard and is likely to delay painful and lengthy structural reforms — such as slashing fiscal deficits and public sector wages — by heavily indebted nations.

Without the painful fiscal restructuring required, the trade-off for temporary reprieves in tension is that the cost of dealing with the debt would only snowball in the future. The decisions on how to unwind government debts and leverage are now political. The uncertain political paths to be chosen by various governments are now policy risks, which investors should consider.

¹ Carmen Reinhart, Wall Street Journal, 02/12/2010

In this issue		May 2010
	The risk-filled recovery		A web of credit market risks