Next crisis: sovereign debt?

Greece slashes government spending as it and other EU nations try to avoid default.

The Greeks make more history than they can consume locally — something its neighbours now lament. Already one of the world’s most indebted nations, Greece ran up an elephantine deficit last year — an estimated 12.7% of GDP, more than four times the limit allowed by the European Union. In early February, Greek Prime Minister George Papandreou unveiled a budget-cutting plan to fix the problem. But many fear that effort will fail, possibly forcing an EU bailout.

This fiscal quandary represents an important test of European solidarity. The EU is a monetary union, as opposed to a political or fiscal one — bailouts are supposedly verboten. And with good reason: rescuing Greece might encourage reckless behaviour by other members, not to mention drive up borrowing costs across the EU. Yet a Greek default might seriously undermine confidence in its common currency, the euro. Given its status as a major reserve currency, the fallout would be global.

Greece’s woes signal a crucial shift. During the past several decades, the usual suspects — Argentina, Mexico, Russia, Thailand — caused noteworthy debt crises. Those episodes were painful but unsurprising — they’re something of a rite of passage for emerging economies. Yet many of those usual suspects got their acts together of late. In Latin America, for example, aggregate debt burdens dropped by nearly half between 2003 and 2008.

Advanced nations like Greece are doing the opposite. Many are piling on debt at rates typically seen only in wartime, as they struggle to prop up their economies and industries amid dwindling tax revenues. The IMF predicts the average debt-to-GDP ratio of advanced economies in the G20 will climb to 118% by 2014, from the 2007 pre-crisis level of 78%. (Many middleincome countries have defaulted with burdens totalling less than 60% of GDP.) The list of offenders is sobering. There’s now an acronym for the sickest men of Europe — PIIGS. (It refers to Portugal, Ireland, Italy, Greece and Spain.) In Asia, Japan’s debt burden is the worst of any developed country. In North America, the United States is poised to blow through its self-imposed debt ceiling of US$12.4 trillion this month. “ Governments now need to avoid becoming the main cause of the next crisis,” warned a recent report by the World Economic Forum. “Many countries are at risk of overextending unsustainable levels of debt, which, in turn, will exert strong upwards pressures on real interest rates. In the final instance, unsustainable debt levels could lead to full-fledged sovereign debt crises.” David Rosenberg, an economist at Gluskin Sheff noted for Weltschmerz, has dubbed sovereign debt “the next wave of instability.”

Sovereign debt crises can be worse than anything we’ve witnessed recently. Once lenders turn their backs on a country, its citizens can expect massive inflation, accompanied by credit contraction. Local asset prices tumble, banking systems weaken and recession inevitably follows. Riots and other incidences of social unrest erupt. And the misery lingers.

History is littered with such episodes. In their book, This Time is Different: Eight Centuries of Financial Folly, authors Carmen Reinhart and Kenneth Rogoff point out two lengthy periods (the 1820s to the late 1840s and the 1930s to the early 1950s) during which around half the world’s countries were stiffing creditors.

Could Greece touch off another such era? Nobody’s sure how bad its situation is: Swedish Finance Miister Anders Borg recently called Greek fiscal statistics “basically fraudulent.” By the IMF’s reckoning, Greece owes about 115% of its GDP. Its outstanding debt is much larger than Russia’s or Argentina’s at the time of their spectacular defaults in 1998 and 2002, respectively.

Officially, though, the situation is under control. The European Commission endorsed Papandreou’s cost-slashing plan, which is intended to bring deficits within EU guidelines. Proposed measures include slashing civil servants’ wages, selling state assets, higher taxes and a war on tax evasion. The EU is playing tough cop, demanding frequent updates on Papandreou’s progress.

Austerity has corrected many past fiscal crises, in Greece and elsewhere. Yet some doubt Papandreou can deliver. Deficit-slaying is politically difficult, particularly when voters are still reeling from recession. “More aggressive spending cuts or tax hikes … could curb or even derail recovery, perhaps inciting social unrest,” warned a recent report by Roubini Global Economics.

But Greece has few alternatives. Borrowing will be costly: although he recently auctioned five-year government debt at a pricey 6.2%, Papandreou complains that foreign lenders now demand “completely unjustified” risk premiums in exchange for lending to his country. By adopting the common currency in 2002, Greece surrendered its ability to print drachmas willy-nilly to cover its debts.

Conventional wisdom dictates that rich countries don’t default. Most would sooner slash social obligations like health care and pensions than risk exile from the corridors of global finance. “We do not expect to see a mass of sovereign defaults,” wrote David Kotok, chairman of New Jersey investment firm Cumberland Advisors, in a recent note to clients.

Yet despite the alternatives, nations still go bust. The moment of default depends not so muchon when nations cannot pay, but rather when they decide the burden has become too painful. Predicting that moment is challenging. Nations seldom telegraph financing woes until they’ve become impossible to conceal. And there’s no magical debt-to-GDP threshold signalling a breaking point. Indeed, credit-ratings agencies, whose primary purpose is to provide opinions on the likelihood of default, have a poor record anticipating such events. Considering the foregoing, readers should keep a weather eye on sovereign debt in 2010.