Appropriating Risk to Sovereign Debt

By Grant de Graf

Sovereign debt can be defined as Bonds issued by a national government in a foreign currency, in order to finance the issuing country's growth.

Cause

In Europe, government debt has escalated significantly over the past few years, ostensibly causing what is known as the Euro debt crisis. The reality is that the European Debt Crisis is complex and a consequence of a number of factors, including:

• off-balance sheet and surprise debt discovery (Greece)
• a failure of the Euro zone economic model,
• potential debt burden realized (real estate in Spain, banks in Ireland)
• the inability of monetary policy to function in step with fiscal policy, 
• the Euro currency and the constraints it imposes on member nations to automatically adjust to economic imbalances through  market mechansim, 
• contagion from the U.S. recession,
• exposure to the sub-prime crisis, 
• a dilution of confidence in nations to service and repay debt, 
• austerity being haphazardly imposed by European central government on its weaker members 
• cyclical economic factors in growth trends
• Inflation (current Zimbabwe and Latin America in the 1980s)

What many pundits argue is the result of the Euro debt crisis, in some cases is in fact the cause, which means that although a dip in the economic cycle was inevitable, the extent of the swing has been exaggerated through harmful government policy and initiative.

Although the debt ratio of PIIGS (as a percentage of GDP) has escalated since the advent of the Euro debt crisis, many developed countries continue to exhibit high levels of GDP. For example Greece (as of 2010) had a percentage debt to GDP of 165, Italy 120, Portugal 109, and Ireland 108, relative to Japan's 208. (See source: List of Countries by Public Debt)

* Source: Wikipedia, Sovereign Debt Crisis

At risk globally, are countries who are exposed to significant debt, but who are unable to function with a successful economic model, which provide investors with a level of certainty that debt can be serviced or repaid in the long term.

In many instances the servicing of debt is effected by other factors extraneous to debt. For example in South Africa, political tension and the instability of the labor force, has more recently affected investors' perceptions of the mining industry, placing the country's key strategic resource in jeopardy.

In some South American countries, drug violence continues to limit the development of industry, as the risk of new investment constrains growth and development.

The extent of a nation's sovereign debt and the risk factor that is appropriated to it, will ultimately depend on the country's economic viability and its ability to meet short-term and long-term obligations.

Impact

• Interest rates of bonds specific to a country increase
• Capital values of existing bond issues fall
• Cost of capital for future bond issues increased
• Possibilty of default in debt repayment
• Central banking institutions (like ECB or IMF) need to buy bonds or take up new issues to keep interest rate in check and take up slack in demand
• Governments need to increase taxes to meet shortfall in servicing of bonds 
• Decrease in investor and business confidence
• Deflation as economies shrink
• Austerity as governments cut expenditure in anticipation of growing budget deficit   

Opportunities

• Countries can buyback debt at lower, discounted capital values
• Potential to renegotiate terms of debt repayment with creditors
• Traders may buy debt (if they anticipate interest rates will fall in the future, and if possibility of debt default is low, or if there is anticipation that currency will strengthen as with South African rand in early 2000s)

Groups at Risk

• Investors 
• Traders
• Stocks and forex
• Central banks
• Investment banks
• Government
• Importers and exporters
• Shipping and industry
• Tourism
• General business
• Bond holders and traders
• Politicians
• Rating agencies
• Civil servants
• Labor unions