Facts and Fiction of Sovereign Debt Default

Since the middle of January 2010, the equity markets have been on a decline, with the S&P500 down nearly 10 per cent from its peak.

Commodities have also seen an outflow of capital with both Gold and Oil down nearly 15 per cent. The latest reason for this risk aversion is being attributed to the specter of sovereign debt default by the PIIGS of the European Union.

The acronym PIIGS, being used by several banks, refers to the weaker European economies of Portugal, Ireland, Italy, Greece and Spain. This fire of sovereign debt default speculation is being further fueled by journalists and misguided economists who have added the UK, Japan and even the US to this list. China has been labeled America’s banker and people have wondered how the US would ever repay the mountain of debt owed to the Chinese, nearly 2 trillion dollars.

This seems like a very opportune time to understand the difference between hard currency and soft currency economics, the difference between Spain, Portugal and Greece’s fiscal landscape and that of the UK, Japan and USA and the misnomer of China as the banker to the US.

When a sovereign nation’s money supply is determined by the amount of hard assets that country holds, like gold or silver, the country’s currency is called a hard currency. The country has to hold a certain amount of gold or silver and be ready to convert its currency into gold or silver upon request. Soft currency or fiat money is not backed by any tangible asset and therefore, the money supply of a soft currency is solely determined by the financial and economic policies of that government.

A soft currency gets it value solely from its ability to extinguish tax liabilities of that country. There is no inherent limit on federal expenses and therefore on federal spending. When the US government decides to spend fiat money, it adds to its banking reserve system and when it taxes or borrows (issues Treasury securities) it drains reserves from its banking system. These reserve operations are done solely to maintain the target Federal Funds rate.

If the US government increased its banking reserves but failed to issue new securities, the interest rates would fall to zero. Now that we understand the mechanics of federal spending and the issuance of government securities, one can see that the spending is done before the issuance of securities and that spending is not curtailed by the government’s ability to place its bonds.

This leads to the next logical conclusion, which is that the government of a fiat currency (US, UK and Japan) can retire its domestic debt without financial constraint. The major effect of having to retire its debt would be that the banking reserves would not be offset by borrowings and therefore the interest rates would fall to zero.

At this point I would like to dispel with the notion that China is the de-facto banker to the US. China runs a massive trade surplus with the US and consequently has accumulated a large amount of US Dollar reserves. China can do three things with these massive US Dollar reserves. It can leave them in zero interest rate bearing accounts, it can purchase US Dollar denominated securities or it can sell these dollars in exchange for other currencies or hard assets, such as Oil, Gold, Silver, etc.

China has been very actively purchasing hard assets but most of its US Dollar reserves are in interest bearing US Treasury bonds. If the US government did not issue anymore Treasury bonds or if China refused to buy anymore Treasuries, the loser is China, not the US, as China will have to leave its US Dollar reserves in non-interest bearing accounts.

Now let us take a look at the way the EU is setup. Individual countries in the EU can only spend what they collect in revenues and taxes. Any extra spending has to be financed via borrowings as the individual countries cannot deficit spend like the US. This is because they do not have their own central banks anymore, and all banking operations are controlled by the ECB.

This is unlike the US, UK or Japan, where the central banks always have the ability to service and retire their domestic debt.

The economic situation with the PIIGS is dismal, therefore given the fiscal landscape of the EU, as described above, there is a real likelihood of a sovereign debt default by its member countries. Portugal’s public debt will rise to 91 per cent of GDP by 2011, according to European Commission forecasts. More than one in three Italian households with a mortgage are behind on their payments, Ireland’s economy shrank 7.5 per cent in 2009 and the government is cutting spending to reduce a deficit that widened to 11.7 per cent of GDP, almost four times the European Union limit.

Greece faces opposition to proposed deficit cuts, with its biggest union set to approve mass strikes. Even though countries like the UK, Japan or the US can deficit spend without financial constraint, there are some real economic consequences to these actions. The largest ramification is on the country’s currency. Increasing the money supply decreases the price of that currency against other currencies as well as against hard assets like Gold.

The fact that the US Dollar still remains relatively strong, given the 12 trillion dollar deficit, is because the US Dollar is still the world’s reserve currency. Sovereign wealth funds and Central banks around the world still believe in holding US Dollars as a financial asset. Long as this demand exists, the US can get away with massive deficits and still maintain relatively high purchasing power in the international markets.

Email the writer: m.agarwal@alrroya.com