Whilst much has been written in the press over recent weeks regarding the problem of sovereign debt in many countries around the world, investors could be forgiven for being confused as to the nature of the issues.
We have seen a number of commentators discuss the US debt issue in the same context as the European and specifically Greece’s debt crisis. These two issues are in our view poles apart, both in terms of the magnitude of the problem and possible outcomes.
For the US, notwithstanding the recent rating downgrade to AA + from AAA, the near term debt problem is likely being overestimated by many. It is true that at more than $US14 trillion the US has the largest pool of Government debt of any country. However, the US is also the largest economy globally.
Greece has by comparison a dramatically smaller debt burden at around Euro 350 billion ($US500 billion). However, it is a much smaller country – its net debt to GDP ratio is above 150 per cent of GDP, more than double the US. However, even this doesn’t tell the full story. The worst aspect for Greece is that the interest rates it must pay on any new debt issued or refinanced have exploded. Greek government debt is now yielding almost 60 per cent for 1 year bonds and “only” 18 per cent on 10 year bonds. As a consequence it is now no longer a question if Greece will default, but simply when. By contrast the yields for equivalent US Treasuries are 0.1 per cent (1 year) and 2.2 per cent (10 year), amongst the lowest globally.
The potential for a default of US Government is effectively zero, despite some misguided views expressed about the inevitability of a US debt default. In reality it is virtually impossible for the US Government to default irrespective how much debt it issues because that debt is denominated in US dollars and the US Federal Reserve can always print more US dollars to repay Government debt.
However, Greek debt is only the tip of the European debt iceberg. And the European debt crisis will not likely simply evaporate. It requires decisive action – now. Europe has the financial resources, should it choose to use them, to underwrite all of Greece’s current and future debt requirements. However, the real concern is the potential “contagion effect” of this crisis on other countries within Europe, most significantly Italy. Italy has Government debt around 100 per cent of GDP as is the third most indebted country in the world. It is highly unlikely Europe would be able to muster sufficient resources to deal with an Italian default. Therefore quite simply this is a crisis that cannot be allowed to spread beyond Greece.
Like an outbreak of influenza in the human population, a sovereign debt crisis can quickly spread to other countries if left untreated. Thus far in Europe, the authorities have lacked the required policy resolve to aggressively control the problem. This needs to change. Effective prevention in this case is likely to be far more effective in managing the debt crisis moving forward than trying to cure the problem if a broader range of European countries are infected.
Is a positive ending to this story possible? At the very least the issues are well know now and understood by both investors and policy makers. Also, we are increasingly under no illusion of the dangers of the “do nothing” approach to this issue. Further significant financial commitments will be required to convince investors that enough firepower is available if necessary to deal with the crisis. This will likely mean a further substantial call on taxpayer money in Europe to supplement bailout reserves as well as a newfound willingness by the ECB to use its balance sheet to provide a large part of the solution. Support on both fronts has been extremely grudging to date. We can only trust that the hesitancy of European policy makers will soon be replaced by a firm and aggressive plan of action.
Michael Karagianis is an Investment Strategist with MLC.
