The Year of Distressed Sovereigns

In our investment process for emerging markets, we'd like to describe typical phases of market development of a country going from distressed, stabilizing, reforming to converging.  An emerging market can move backwards from its current phase too.  Therefore an emerging market may have emerged/converged, but due to bad economic policy or political leadership, the country submerges and goes back to the distressed phase e.g. several of the investment grade-rated Asian countries during the Asian Crisis in 1997-1998 or several of the Baltic countries during the 2008 global financial crisis.

We normally would not apply these dynamic phases of market development to developed markets including the US, Japan and Europe.  But there you have it.  This may look like the year of many developed markets going into the distressed phase.

A recent Bloomberg article calculates that the world leading economies have more than $7.6 trillion of debt maturing in 2012 ($8.8 trillion if interest burden is included) and face rising borrowing costs.   


Here are the redemptions schedule of the G7 + BRIC countries for 2012 (source: Bloomberg):

These are large numbers. According to the Boston Consulting Group (BCG), the numbers are more alarming if the costs of providing for the elderly are included in the government's liabilities:



The above takes into account the government liabilities only. OECD tabulated that the 18 core OECD countries total debt to GDP (counting government, non-financial corporations and household debt) rose from 160% in 1980 to 321% in 2010.  BCG estimates that should we need to stabilize total debt at 180% of GDP then the debt overhang would be €6 trillion for the Euro zone and $11 trillion for the U.S.; should the debt ratio be stabilized at 220% of GDP, the debt overhang would be €2.6 trillion for the Euro zone and $4 trillion for the U.S.  That is the amount of debt that needs to be reduced.

The European Banking Authority has just announced that European banks need to recapitalize a further €115 billion which could imply that the banks need to retrench their balance sheet by €2 trillion. 

Essentially to reduce debt, a country can save more, grow more, default on its debt or inflate the debt burden away.  With fiscal austerity program in place simultaneously for many developed countries, growth, unemployment and therefore consumption would bound to suffer.  To ask the countries to save more is to require them to run higher trade surplus.  However global imbalances mean that the surplus countries cannot simultaneously increase their consumptions fast enough to save the trade deficit developed countries.  That leaves debt default/restructuring and inflation, which seem to be the roads inevitably being taken.  

When the Fed started raised interest rate abruptly in 1982, several of the spendthrift developing countries simultaneously defaulted.  Unless the Fed and European Central Bank engage in large-scale quantitative easing to "underwrite" the sovereign obligations, voices of debt repudiation are ringing louder and louder that several of the sovereigns could simultaneously default (this time is the developed countries).