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May 2010
Rethinking Sovereign Risk – Part II
In our fourth quarter 2009 letter we wrote on sovereign risk warning about the
implications of the sizable U.S deficit. Since then, concerns about Greece and
other European countries have overtaken markets and the financial community has
focused its attention on the possible implications of Greece’s inability to refinance
its debt. Greece and other European countries provide a glimpse into the dangers
of excessive government participation in the economy. With the impact the
European debt crisis has had on markets, we think it is an opportune time to review
the concept of sovereign risk, explore Europe’s “Catch -22” dilemma, and consider
implications for the U.S. and other countries in this period of government
expansion.
Lessons From the Past
In the 1970s a famed Citigroup Chairman boldly pronounced that sovereign nations
do not go bankrupt. After lending millions of dollars to countries, principally in Latin
America, Citi was forced to spearhead countless Restructuring Committees as
country after country defaulted in the early 1980s. Mexico led the parade in 1982
after the sharp increase in interest rates at the end of the 1970s made it impossible
for the country to service its sizable debt. With Mexico’s problems, the spigot shutoff for every other country and Argentina, Brazil, Chile, Venezuela, and others
followed Mexico to the restructuring table.
In Latin America governments controlled many industries and ran famously corrupt
and bureaucratic operations. Having built large debt burdens to finance
infrastructure and inefficient industries, the countries were saddled with high
inflation and an ever growing debt load. Early restructuring proposals involved
extending near-term maturities to give the countries time to fortify their fiscal
accounts and eventually pay their creditors. The proposals were accompanied by
currency devaluations and recommendations for privatizations and trade
promotion.
The early efforts did not work. Sovereign analysts blamed the countries’
intransigent bureaucracies and inefficient government-run industries. Toward the
end of the 1980s, the global financial community adopted the Brady Plan, named
after then Secretary of the Treasury, Nicholas Brady. The plan involved a
mechanism whereby countries could cut their obligations, while financial institutions
did not have to write down their loans because of the use of long-dated zero
coupon U.S. Government bonds. With the participation of the IMF and reduced
debt burdens, countries began to implement reforms intended to reduce the size of
government and augment the private sector.
Sovereign Risk Analysis
Sovereign risk analysis has traditionally applied to nations with lower credit ratings,
meaningful external debt, and, often, some history of credit problems. Investors
have distinguished between sovereigns whose key source of risk is credit and
those whose key source of risk is interest rates. To a large extent that distinction
has divided developed and emerging markets, until now. Greece has many of the
“red flag” elements of traditional risk analysis: large budget deficit, high debt/GDP
ratio, low foreign investment, and a shallow domestic capital market.
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However, it was the recession of 2008-2009 that exposed a flaw that is common to
most European countries and was previously little noticed - government
expenditures constitute over 40% of GDP, a level that raises an impossible policy
dilemma.
At a time of crisis it is incumbent upon affected parties to make adjustments.
Private sector companies reacted swiftly and forcefully to the recession by cutting
costs and reducing employment. Governments find it much harder to slash costs
because of both the political cost and the absence of a mentality of productivity. In
the face of recessionary conditions, Greek and other European governments will be
forced to implement austerity measures, but their implementation has an immediate
negative impact on GDP. Using Greece as an example, a contraction of 5% in
government expenditures, will reduce GDP by over 2%. To overcome a budget
deficit in excess of 10% of GDP, crippling taxes must be imposed on the productive
sectors of the economy. In addition, the country’s inability to refinance has caused
a sharp rise in the cost of debt. With debt over 100% of GDP, every 1% rise in the
cost of borrowing increases the government’s deficit by over 1% of GDP,
necessitating an even sharper contraction in GDP to arrest the problem. With a
hobbled private sector and limited foreign investment, it is difficult to find offsetting
contributions to GDP. The riots we have seen on television are a further
manifestation of the problem.
Many commentators have suggested Greece’s problems may break up the Euro
and that the single currency construct is untenable. These same analysts propose
that countries like Greece need to be able to devalue their currency as a key policy
tool. This is surprising given the experience Latin American countries had with
devaluations, intractable inflation, and the expectation that somehow impoverishing
its citizens would make the country better off. True, an austerity program focused
on cutting government expenditures will increase unemployment and contain wage
growth, but, properly complemented with measures to encourage private sector
investment, this solution restores the standard of living more quickly. Brazil,
Mexico, Chile, Colombia, Philippines, Indonesia, and many others can be cited as
proof that small government attracting private investment is a much better solution
than devaluations and taxation.
A Word of Caution
Europe’s problems should be a warning to the U.S. as we embark on massively
expansionary government. Historically, government spending in the U.S. has only
contributed about 20% to GDP. In 2010 participation is expected to rise to about
26% and the recently enacted health care legislation will cement a program whose
cost may reach up to 10% of GDP in a decade. Furthermore, with this year’s
budget deficit near 10% of GDP, we will have a debt to GDP ratio near 100%.
While the U.S. government does not fund in foreign currencies, it does rely on
foreign sources for much of its borrowing. Once government’s share of the
economy becomes too large, it becomes socially and politically difficult to reverse.
If we want to maintain a dynamic, high growth economy, we must reverse this
expansion of government, before outsiders force us to.
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GIA Partners
At GIA Partners, credit is in our DNA. We are bottom-up credit managers who have
managed credit portfolios in virtually every part of the world’s fixed income markets
as well as through some of the most severe credit events in history. We have a
thorough understanding of fixed income investments and their role in a globally
diversified portfolio, and our clients have been rewarded with strong and consistent
performance.
For More Information
Gloria E. Carlson, Director
Sales and Marketing
GIA Partners, LLC
12 E. 49th Street, 36th Floor
New York, NY 10017
212 893-7835
[email protected]
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