The 2010 - .... sovereign debt
( State debt ) turmoil

After the sovereign bond bubble,
a risk of country default and of systemic crisis?


Financial asset markets were, and still are, in turmoil because of
worries about the state of the sovereign debt of several countries.

Various market players still fear a cascade of country debt defaults,
and thish as an impact on financial market evolutions.

Note from the author:
The issue is strongly linked to another one, we have twin menaces
here, the risk of a
world currency collapse.

What is happening?

Did your government make you and your kids broke?
sous The financial asset markets have been and are still in turmoil,
notably in relation with the perilous state of various countries' sovereign
debts (usually as government treasury bonds...).

Such a financial illness was usually in the old days limited to some
developing countries, for some of them (Argentina....) recurrently.
But it reached more recently several developed ones.
Iceland, Greece, Portugal, Ireland, to start with were directly
hit and are still not totally cured (Greece is on a tightrope)  Strong
pressures also affected Spain and Italy.

As seen below the assault has been, up to now, directed towards
some
Eurozone countries.
There is here a (political ?) paradox when you see that some of
them, such as Germany are highly performing, with no budget
deficit, that the Euro currency did not show really permanent
weakness (except the current rebalancing, contrarily to the US
dollar, and that potentially,
some big countries (look at the
Japanese massive debt) could be
ready for the dive!

Another thing is that small currencies are quite uneasy to
manage by their central bank
Lenders and market players are fearing "sovereign debt defaults"
(aka State debt defaults)

The process is as follows:

They realize that it will be unable to repay it in the future
(state of insolvency).


When a country's public debt (*) became extremely huge
and reaches 80 - 100%
of GNP,  its administration can be
suspected of having entered a Ponzi (pyramidal) system

in which old debt can only be repaid by finding new lenders, 
who would not be easily convinced.


Many players become reluctant to lend more money, even
to meet immediate expenses and maturities (liquidity
crisis).


Local or global?

With some political asymmetry ?

What happened in practice
, for the country directly affected, is that those
financial players got rid of the debt they owned on them at a discount and /
or asked for huge interest rates
to lend them any more.
Those countries have seen their bond prices tumbling and their interest
rates
climbing (bond crash).

Also, by contagion, the global stock exchanges and foreign exchange markets

went highly volatile.
The label "Euro crisis" has been used in April-May 2010, as the
European currency was then under attack (but emerged stronger
at the end) on foreign exchange markets.
Also the most indebted European countries have seen their ranking
severely downgraded notably in 2011-2012.


At the end of this article, more details are given about the Euro case
But still nothing shows that the issue can be limited to Eurozone
countries.

Actually, the Euro is still quoted at a premium on the Forex, and
doubts are expressed about the fiscal situation of some major
non European countries
(Japan, United Kingdom and, more
worrying, and massive, the US of A...).

In fact a "Dollar crisis" is also affecting markets
.
(*) Actually there are differences between

      A State debt
       (the one issued by a country's Treasury),

      A public debt
      (it includes also the municipalities, province or federated states debt)

      A country debt
      (including also households, businesses and other resident entities debt)

danger More generally, market players as well as some financial institutions
started to believe in the prospect of a "domino effect", a global systemic
crisis" that would affect more and more (and bigger and bigger) countries,
including the mammoths public deficit
and debt, Japan, the UK and ...the US
(16 trillion dollars for this last one, wow!).


They fear a cascade of "sovereign debt defaults" (see the next section) by
those countries.
It was not crystal ball but I stated that risk in May 2009 in the
section: "Will the second shoe fall? Will a second crisis ensue?"
in my chemical
toxic debt and subprime crisis article .
At that time I did not see the high flying world economic pundits
mentioning the menace. Well, later the issue made the headlines.

I'm sad that I was right, and even sadder that Europe and specifically
the Euro were the primary target, in spite of US public and private
finance having been managed in a massively riskier way for a much
longer time
.
And still will be if politicians keep being unable to agree on solutions
to the budget imbalance

Finally the US debt lost its Standard & Poors AAA debt ranking in
Aug. 2011.

We might wonder why the debt rating agencies were so blind before
(as they were also towards the institutions that created the subprime
fraud). Seems those agencies trust the USA to create more money to
refund its debt at maturity.
But what would be the value of this bottomless
flood ocean of
money?

The equik unbalance was not caused only by the US subprime
crisis
, and the huge funds that had to be injected as a consequence to rescue
the banking and financial sectors, but also by a widespread budgetary
and monetary mismanagement
, typically in the US in the last decade,
but with older seeds.

The rateher widespread illusion was that economic growth could be bought
endlessly
with credit. Even the theories of some respected academics such as
Keynes and Miller-Modigliani helped fuel such lever "overleverage"
distortions
that privileged borrowing over saving.

The question now is about the immediacy and scope of
the
"systemic" risk. Is it overstated or under-stated?

There is much uncertainty about that.
History has shown that markets might be overreacting after a phase
of under-reaction (see
reaction and misreaction to information).
They might also fall into a self-fulfilling prophecy, make their
expectations become realities, what Soros calls
feedback "reflexivity"
(the observers' perception can change the fundamentals they observe).

As an example, rating agencies and hedge funds pushed some sovereign
debt rates higher, as creditors discover the risk entailed. But it made
the burden less bearable for the related countries, thus increased the
said
risk. In the same way, some austerity measures sent the affected
countries in recession which degraded even more their budgetary
situation.

Practically, what factors and menaces arose?

To understand why the financial, economic and financial circles are worried,
we have to detail here the two factors that have led to the situation and
which are now far from easy to tackle

1)
An habit of easy money and low rates that, in many places, following
     the example of the US

* It bolstered consumption above production capabilities,

* It induced
State over-spending
, financed by what had all the traits
   of a sovereign bond bubble

* It favored
excessive financial speculation
. The money overflow
   reaches the financial sphere when it does not find uses in the
   economic sphere.

2)
A transfer of debts and risks to public budgets and central
      banks
to rescue financial entities that
the subprime crisis could have
      made bankrupt.

As a consequence several worries are still presents:
  • There are doubts about the capacity of many governments
to reduce such huge debts, even when the economy picks up.
  • Nobody is certain that highly indebted countries will find
enough lenders in the coming years and at a reasonable cost.
  • Some "unorthodox" schemes has been put in place,
such as financing states with money created by central banks,
It is called "quantitative easing").
It creates a monetary danger on inflation and foreign exchange
rates.

Worse still, in case of sovereign debt crash, those central banks
already encumbered by those debts, would not have the capacity
to support their market further in a massive way.
A crisis of trust might reach them, and also the money / currency
they issue, given the dubious quality of assets in their portfolio.
  • Actually, those central banks injected massive liquidity liquidities,
This, instead of deterring speculations by banks, incited them to
enter new games.
To take one aspect, the bank's trader's bonus issue stays largely
unsolved

No preparation have been really done at the global level to tackle a possible
systemic crisis that would involve:
  • Money markets (interest rates) and foreign exchange markets
(the US dollar issue, temporarily hidden by the Euro issue).
A
menace of global monetary crisis unless a refurbishing of the
world monetary system takes place urgently
A growing distrust towards most major central banks
and their currencies
could create a monetary tsunami.
(see
towards a world currency)
  • Government bonds from many countries (the new toxic debt),
  • and all bond markets more generally, in a bond market crash.
  • Banks ...again, a
s they are among the main lenders to governments.
Sovereign bonds were even considered a few years ago by
them as the safest and most liquid assets.
Anyway, the US and EU lawmakers decided in July 2010
stricter rules on bank activities and their capital adequacy.

  • Governments lending to themselves
via their central banks They buy Treasury securities as
monetary reserve but also in a "last resort" to rescue those
drowning and debt-addicted states.
  • Stock markets,
because of the risk that the (weak) economic recovery out of the
subprime loan - related recession
will stop because of a lack of
liquidity when banks become afraid to lend.
  • This disguised self-lending smacks of a near delictuous book-keeping
operation that used the central bank as an accomplice or hostage.

Of course there is a strong interference between two categories of
players: banks vs. States / Central banks.
Banks lend massively to States and States / Central banks give massive
financial / monetary help to banks.

Two drunkards helping each others to stand upright in the street?

The fact that central banks are asked to contribute to the general
rescue
, with very low refinancing interest rates and, after purchasing
dubious bank assets during the subprime crisis, now buying risky sovereign
debts, relieves some tensions in a first phase.

But this magic trick of "lender of last resort" is a source of new uncertainties,
not only about how safe are those institutions with unprofitable or risky
assets in their portfolio and also on the value of the money they issue.

Of course commercial banks (that participate in creating and storing
money in deposits, and use some refinancing from central bank), insurance
firms and investment funds
with large amounts of sovereign debts in
their portfolio, run the same risk.

Overall consequences. Then, what to do?

The asymmetry

Now we are in a strange and crippled economic world that walks
on two asymmetric financial legs:
  • Many developed countries that lost their economic rent
and are highly in debt,
  • Several emerging ones have been lending massive amounts to them.
What will come out of this unprecedented and highly conflictive
situation
?

Both "sides" will certainly suffer, although we cannot really know to what
extent

Their economies would be submitted to serious shocks.

What to do?

A debate will certainly arise about how to fight the worldwide conflagration:
  • Will the debt be mopped out by a general inflation or a  deflation (*)?
And for some countries by organized defaults (via moratoriums
and write off of a part of their debts)?
  • Or would a general debt restructuring agreement intervene
(and also a new world monetary standard)?
  • But what would be the risk for bank, insurance, funds and their clients?
Anyway, it is one of several crucial contemporary issues that raise the
need for global institutions and
democratic globalisation.

(*) It seems that
      * the US favors to pursue its usual lax policy: trying to cure its debt
           obesity by adding more debt, under pretense of helping economic
           growth (for how long?),
      * while Europe opted for a fiscal responsibility based on the reduction
           of public deficits, to reestablish the trust of economic players.
=>
This leads to the next section about the Euro case.

The euro Euro case:
red herring or serious warning?


. Why the attack?

The irony was that, although the highest global financial risk is in the
mammoth US Treasury debt, the financial markets attacked the Euro
in Spring 2010, via the Greek debt market (a country that is only
2 % of the European Union GDP).
This appeared a bit like a red herring to ease the pressure on the US
dollar and US bond markets.

Even the US administration soon noticed that the maneuver could be
counter-productive, as the global economic recovery could be hindered
by such troubles, and it pushed for a rescue plan.

. What is lacking?

Anyway, the onslaught revealed some flaws in the Eurozone governance.
The EU was responsible of not tackling the question of how to organize
seriously a common economic *and financial equil balance
within its geographical area
.

The country debt guidelines of the Maastricht treaty, however
legitimate, and now reinforced in their application which was rather
lenient before the crisis, might not be a fully efficient substitute to what
should be:
  • A real common economic governance,
It would use incentives to boost productivity and competitivity
in a drastical way when facing more dynamical world areas. 

A better balance between the individual economic performance
of all the countries of the Union should also be a goal.
Common economic governance should not of course be "dirigism"
and overregulation, but at least would define some common goals,
to have some common projects and build common economic
benchmarks.
  • Coupled with the creation of a European (or at least Eurozone)
Finance Ministry / Treasury, It would have its own budget,
apt to centralize some common taxes (VAT?) and issue
eurobonds at the start through a Eurozone Agency.
  • A better limitation of member-states borrowing possibilities. 
As a counterpart to those common financing tools,
The common EU guarantee would be given only to debts below a
certain percentage of their GDP, sorry for the lenders.
Also a European control on member State initial budget blueprints
is needed and starts to be enforced.

. What European
safety / orecaut responses so far?

Most countries in the Eurozone became quite active, under the lenders
pressure  relayed by rating agencies and by the European authorities
(with a stricter control and sanction system), in trying to reduce their
debt through sizable fiscal efforts.

The May 9th 2010 the Eurogroup, the coordinating body of the
Eurozone (*),
launched a rescue / collateral line to cover wobbly
national debts amounting to 750 billion Euros = 1000 billion US dollar,
notably through a 440 billion E fund called the "EFSF European
Financial Stability Facility".

On Oct. 27th 2011 the EFSF financial capacity was increased to 1 billion E (**) ,
by allowing it to offer its collateral to a fraction (between 20 and 30%) of the
lenders' contributions.

The EFSF is progressively replaced by a full fledged financial fund
(the ESM, European Stability Mechanism), with a 80 billion Euros
equity subscribed by the Eurozone States.

The EFSF was limiting itself to refinance States, but was also authorized to
recapitalize the ailing Spanish banks. Also the eurozone banks get medium
term loans (36 months) with a low interest rate from the ECB
(***)
Previously  the banks suffered a "voluntary"50% "haircut" on the Greek debt.

The ECB
(***) has decided (Sept. 2012) to buy on the market (OMT /
outright monetary
transaction) an unlimited amount of sovereign
bonds with a maximum
3 years duration, bearing the related risk, but only
if if issued by countries with a gradual debt reducing plan accepted by
the EFSB/ESM
.

Previously, it was also decided that the ECB manages technically the
EFSB/ESM
.

This weight put on the ECB as the primary firefighter limited the conflagration
but what it it put the ECB itself in the situation of a flamable institution?


(*) 18 countries among the 28 European union countries.
The other 11 still don't use the Euro, some of them just because they are not
ready. The UK was alone in rescinding any prospect of joining it and voted
against the support package in Dec. 2011.

(**) The final amount might be higher, thanks to the contribution to
specialized funds by various emerging countries with huge monetary
reserves
and wish to bolster the Euro, because of, among other reasons,
a distrust towards the US dollar. The IMF could contribute also.


(***) European Central Bank, the Euro currency system pilot.

Another thing is that a full bailout of deficient countries could give a
perverse incentive to lenders.
A partial bailout via some debt restructuring (****) is preferable
so as to make them bear some losses (the haircuts mentioned above) on
their imprudent loans.
A 50% haircut for private lenders has been agreed upon for Greece. But the
problem is far from solved and the Greek crisis burst again
dramatically in 2015

Normally the prospect of new haircuts on other country debts has been
barred by the Dec. 2012 agreement.


(****) A debt haircut involves increasing the duration, lowering the
rates,
and even lowering the total amount to be repaid.

. Other possible, but still pending, Eurozone decisions

Two rescue tools are discussed but still face a strong German opposition:
  • Direct ECB loans to States
(possibly under the intermediation of the EFSF that would then
become a bank). That would go further than buying existing
loans
at current rates in the secondary market.
Actually the circuit is indirect and imply the banks (1 000 billion
euros of three year ECB loans to commercial banks, that use a
part of the proceeds to invest in EU sovereign bonds) and the
IMF.
within a fraction of their GNP, guaranteed by the Eurozone (or
direct issuance of common bonds by the Eurozone / Eurogroup
itself).
Of course, such instruments should be devised and used carefully
to avoid to increase the whole area indebtedness.

All those moves, however helpful (and for some of them still pending), could
be seen as insufficient steps towards what should be a full-fledged

EU - or at least Eurozone - Treasury including a common fiscal
resource.


More generally, as long as there is no progress towards a true
European federation
, Europe will
find itself marginalized in a world
which economic and political balances are rapidly shifting.


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M.a.j. / updated : 15 Sept. 2015
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