In the red

Is sovereign the new subprime? Following the recent events in Iceland, Greece and Dubai, Tom Toulson examines the risks to the global economy posed by sovereign debt.

What difference a decade makes. Ten years ago the market for government debt appeared to be dwindling. In 2000, governments worldwide issued a combined total of $250 billion worth of bonds. This year, the UK alone plans to sell £225 billion ($360 billion) of gilts. Governments around the globe are borrowing more because of the financial crisis. Some of them are in serious trouble. Recent events in Iceland, Dubai and Greece have caused concern amongst bond investors over the security of sovereign debt, once thought to be the safest of all asset classes.

Next month, Iceland will take the unusual step of voting on the issue of whether or not to honour a national debt. It is part of the continuing fallout from the Icesave affair. Thousands of UK and Dutch account holders lost their savings when the Icelandic banks, such as Landsbanki, which offered online, high-interest savings accounts, went bust. Though not yet a member of the European Union, Iceland is part of the European Economic Area, which means, in theory, that British and Dutch savers should have been covered by Iceland's deposit guarantee scheme. This protection was at best theoretical because Landsbanki's liabilities far exceeded Iceland's GDP. In June, the British and Dutch governments, in order to compensate their own citizens, made a 15-year loan to Iceland's deposit guarantee fund.

The Icelandic government agreed to repay £2.35 billion to the UK and £1.2 billion to the Netherlands. However, the British and Dutch rejected certain conditions of the repayment deal. The Icelandic government sought parliamentary approval for a compromise proposal. More than a quarter of the electorate signed a petition opposing repayment. The Icelandic President, Olafur Ragnar Grimsson, refused to sign the bill and the parliament voted to hold a referendum on the issue. In response, the ratings agency, Fitch, downgraded the country's credit rating to "junk" status.

The debt is equivalent to a third of Iceland's GDP. The burden works out at around £40,000 per household. Icelanders are being asked to vote for higher taxes and deeper spending cuts, which could cause a rise in unemployment and damage any economic recovery. There is widespread public anger. Why should a bankrupt country be forced to repay rich foreigners for the failure of a private bank? If a British bank had gone bust, would UK taxpayers vote to repay foreigners who lost money banking online?

And yet Iceland may not have much choice. A refusal to repay the debt is likely to lead to international isolation, which the country can ill-afford. Iceland's bid for membership of the EU and its continued access to loans from the International Monetary Fund (IMF) both depend on a resolution of the dispute. Both are also vital to any economic recovery. Iceland is seeking $7 billion in IMF loans, most of which is supposed to come from the Nordic countries. Finland has already warned that the next instalments may not be forthcoming. The Icelanders are well aware of the consequences of being cut off from further funding. For this reason, the outcome of the referendum is by no means certain. 53 per cent of those polled in a Gallup survey said they would support the bill, which requires a simple majority to pass into law.

Iceland's predicament has divided opinion amongst UK financial commentators. Many argue the country should simply pay its debt or face the consequences. Others suggest the UK is bullying a weaker nation into doing what it would not countenance were the roles reversed. The debt in question is less than one hundredth of the amount the UK hopes to borrow from the markets this year. It's possible that we could afford to be a bit more neighbourly. Iceland's lawyers argue that the country is under no legal obligation to make the reimbursement. It is unclear whether its domestic deposit guarantee scheme places the state under enforceable obligations to foreigners.

Iceland is not the only state in recent weeks to deny responsibility for repayments. Dubai recently claimed that the debts of the property company Dubai World could not be passed onto the state. Neighbouring Abu Dhabi intervened to resolve the situation - but for how long? Bond investors are understandably nervous. Could a Western state default? All eyes are on Greece, the eurozone's weakest performer.

In November, the new Greek Finance Minister, George Papaconsantinou, announced that the budget deficit for 2009 would be much more than the government had previously admitted. Instead of the predicted 6 to 8 per cent of the country's economic output, it would in fact be a huge 12.8 per cent, or €30 billion, bringing the total debt level to 110 per cent of GDP. The ratings agency, Fitch, downgraded the country's credit rating to triple B status, Standard & Poor's gave the country a negative credit outlook.

Last week, Mr Papaconstantinou announced plans to cut the deficit to under 3 per cent of GDP by 2012, a highly ambitious target when one considers that it took Greece nine years to achieve a similar reduction in the 1990s. He expects the economy to shrink by 0.3 per cent this year but to grow by 1.5 per cent in 2011 and by 1.9 per cent in 2012. In order to achieve this recovery, Greece plans to borrow €54 billion (£45 billion) of bonds this year. However, the markets are unconvinced by the plans. The cost of insuring against a default on Greek sovereign debt rose to the highest levels since the market was established in 2004. Bond prices fell to their lowest levels in a year, pushing yields up (making borrowing more expensive). Investors have taken the view that the targets for reducing the deficit and for achieving growth are incompatible.

The president of the European Central Bank, Jean-Claude Trichet, has publicly ruled out the possibility of a bail out. European diplomats are furious that Greece hid the true size of its deficit for so long with doctored figures. And yet it is extremely unlikely that Brussels will allow a member state to default on its debt. It would seriously damage the whole European project of economic integration. Furthermore, if investors are badly stung by Greece they may start to desert the whole eurozone area. Stronger European neighbours might end up paying more for their borrowing.

International pressure from the ECB may actually help Mr Papaconstantinou sell unpalatable proposals to the voters. The plans involve severe cuts to the health and defence budgets and reform of the expensive pension system. Sacking public sector workers will not prove popular. Unemployment is already at 9.8 per cent. Negotiations with trade unions over pension reforms are proving difficult. The unions are also unhappy about cuts to the benefits system. Greece has submitted the plans to the European Commission. However Brussels may demand even deeper cuts before they are approved at the meeting of EU finance ministers next month.

Greece is not the only European country grappling with a large deficit. Ireland, Portugal and Spain all face the pain of rebalancing the books. And then, of course, there's the UK, where plans to tackle the £178 billion budget deficit have been postponed until after the general election. The government has argued that cutting spending too soon would risk a "double-dip" recession. The delay, however, has created uncertainty amongst investors. The ratings agency, Standard & Poor's, has given the UK's AAA credit rating a "negative" outlook - a warning, in effect, that it might be downgraded. One of UK's leading fund managers, Invesco Perpetual, has said they believe this is highly likely to happen. A downgrade would almost certainly cause the price of gilts to drop and yields to rise precipitously. It would become more expensive for the government to borrow from the markets - an alarming prospect when one considers that, according to the Debt Management Office (DMO), the UK plans to borrow £500 billion over the next three years.

There are signs that the markets are already treating the UK like an AA country. The cost of insuring against default on UK government debt (through credit default swaps, or CDS) is more in line with Japan, Portugal and Ireland than with the US or Germany. In fact, judging from the CDS markets, the UK is more likely to default on its debt than Rolls Royce, the aerospace group - the price of insurance is 81 basis points (or two-fifths) higher. However, it's possible that this may only serve to illustrate the danger of reading too much into the CDS markets, which some argue are little more than a form of glorified spread betting. Rolls Royce, after all, do not have the option of printing more money to meet their repayments.

So far the value of UK debt has remained fairly steady. The price of ten-year gilts has fallen (yields rose from 3 to 4 per cent during the course of the last year) but not dramatically. In other words, investors have been prepared to buy UK government debt. But for the last twelve months they've been able to sell it on to the Bank of England. The Bank's quantitative easing (QE) programme has seen it buy £200 billion of bonds. However the scheme is widely expected to be put on hold when the Monetary Policy Committee (MPC) meets next month. What will happen when the Bank is no longer acting as buyer of last resort? Will the markets be able to absorb the flood of gilts? The Financial Services Authority (FSA) may force some of the commercial banks to buy gilts in order to meet new capital-ratio requirements. However, all this remains highly uncertain. It seems probable that when QE comes to an end there will be an oversupply of gilts - leading to lower prices, higher yields and an increase in borrowing costs. Paradoxically, any recovery in the wider economy may make matters worse. If companies start posting healthy profits investors are likely to switch to corporate bonds (the Rolls Royce effect).

The problems shared by (but not limited to) Iceland, Dubai, Greece and the UK are symptoms of the third and final stage of a global malady. The virus began in the financial markets, spread to the wider economy and has now been absorbed by sovereign states. Unfortunately, it is far easier for states to leverage (borrow and invest) than deleverage, and fiendishly difficult to do the latter during a downturn. Last month, the credit ratings agency Moody's spelt out the problem in a report entitled "Sovereign Risk". It warned that bond yields would rise sharply unless central banks withdraw their stimulus programmes. Yet doing so too quickly could damage growth, causing stocks markets to fall. The central banks cannot afford anything less than perfect timing. For that reason, this year, the risk of developed countries defaulting on their debt is real.

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