Sovereign default: Where does the greatest risk lie?

For the past three weeks, the financial world’s attention has been focused on the spectacle of Greece’s credit problems.

First Iceland and now Greece faces the specter of sovereign default. The financial media warns us that other European Union nations, Spain, Portugal, Ireland, and Italy, may also fall into default like dominos toppling one after the other as contagion spreads. Is this diverting attention from the financial problems of the United States, Japan and the United Kingdom?

The United States, once again, has taken on the role of safe haven as the US dollar has rallied. International flows of speculative money searching the globe for the highest returns have helped reverse the fortunes of the dollar, at least temporarily.

Revelations about Greece’s fiscal problems have helped to spark a short covering rally in the dollar, primarily against the Euro. Gold, which typically moves inversely to the dollar, has rallied along with the dollar, printing record high prices in Euros. US stock markets, highly correlated to the fate of the dollar, have also arrested their fall.

The Euro, which had reached over 1.5 Euros to the dollar in early December 2009, has weakened. We believe that, with the exception of a rising gold price, these outcomes are precisely what the American and European monetary authorities want. They cannot afford for the dollar to collapse, at least not quickly and not now. The objective of the Federal Reserve Bank is to slow the fall of the US dollar lest it become a disorderly route. The Europeans would prefer not to have a strong Euro cripple their export markets and are happy to have some breathing room, if only temporarily.

In reality, Greece contributes only 2.6 per cent to the Gross Domestic Product GDP of the European Union. Its debt is smaller than that of the state of California in the United States. The Euro zone’s budget deficit to GDP is 6.7 per cent and debt to GDP is 88 per cent while the US deficit is 10.7 per cent and debt to GDP is 92 per cent.

Note, however, that the 92 per cent figure does not include off-budget items such as losses from federal mortgage guarantees that, if counted, would balloon the debt to GDP to a more realistic 130 per cent. Similarly, the UK will post a fiscal deficit of 12.8 per cent of GDP this year exceeding Greece’s 12.7 per cent of GDP. Japan’s debt this year will equal 225 per cent of GDP.

All of the above mentioned countries are likely to be technically bankrupt at this point in time. The worst situations occur in Japan, the US and the UK. The greatest risk of default lies in these countries. The greater risk is due, in part, to the probability of a default event, but it is also greater due to the magnitude of the consequences if one of these larger economies defaulted compared to a country like Greece.

Unlike Greece which can’t print money, these countries can attempt to monetize their debt problems by printing money - which the United States has been doing for some time - a course of action that could easily end in hyperinflation. A hyperinflation would be tantamount to a default because the debt obligations and currency become worthless.

The US debt problems are compounded by the continued unwinding of derivative problems engineered by American banks, a new wave of home and commercial mortgage defaults and a low savings rate. The US must borrow, through the roll over of current debts and new debt issuance in excess of 3.5 trillion dollars in fiscal 2010.

The world, especially the Chinese, have cut back on their financings of US debt, thus obliging the Federal Reserve to monetise by purchasing themselves 300 billion of the government’s debt that foreign and domestic investors would not buy. The ongoing debasement of the dollar through the process of monetisation will further erode foreign investment and create a self-reinforcing cycle of decline in the value of the dollar.

The US already monetising its own debt and running out of willing creditors is teetering on the edge of creating a hyperinflationary collapse of the dollar; perhaps its fate is already sealed. Realising this, monetary authorities both in Europe and the United States will do whatever they can do to keep the dollar from crashing.

They will divert attention from their problems by using instabilities elsewhere in the world, Europe, and perhaps Japan in the future, to manage the decline of the US dollar. The financial media will also be used to shift sentiment in favour of the dollar whenever the opportunity arises. Investors would do well to bear these thoughts in mind as the rest of 2010 unfolds.

* With contribution from Bruce H. Pugesek, President of Voyageur Research

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