Wednesday, June 10, 2009

Sovereign Debt Crisis Explained

Sovereign debt is the debt a government owes to people outside the country. (e.g. foreign banks or foreign investment trusts who bought government bonds)

If a private firm defaults on debt you can pursue the debt default through legal means. But, when a foreign country defaults, there is usually no legal recourse of action.

Usually, governments are seen as reliable debtors because their track record shows no debt default. However, certain developing countries have defaulted on debt payments causing

Sovereign Debt

If a country has debts issued in its own currency. e.g. US sells bonds denominated in dollar. If the US ever struggled to finance its debt it could print more money to inflate away the debt. This would create inflation and discourage future investors.

Sovereign Debt in Foreign Currency.

The problem is more severe when a country owes money issued in a foreign currency.For example, Icelandic banks took on many foreign mortgage debts.

Latvia has many bonds issued in Euros. Therefore when the bonds are due for repayment they need to find the foreign currency to pay their debt obligations.

For example, Latvia faces a sovereign debt crisis because according to Fitch Ratings foreign debt maturing in 2009 is equal to 320pc of foreign reserves. (e.g. Latvia holds many euro, Swiss franc, and yen mortgages.) It owes more foreign debt than it has foreign currency.

Is the UK Facing A Sovereign Debt Crisis?

  • UK government debt has increased sharply (12% of GDP this year). There is little chance of an improvement in public finances in the medium term without imposing painful choices on government spending and deflating the economy.
  • Quantitative easing could create inflation and devalue the Pound making investors want to leave UK.
  • S&P rating agency said it was likely to downgrade UK's triple A credit rating.
However,
  • Comparatively, the UK is not exceptionally bad.
  • Some countries like Ireland and Spain have already had their credit rating downgraded.
  • A small downgrade from triple A rating is still a long way off a rating of CCC we see in the likes of Latvia and Ukraine
  • If investors flee the UK where would they go? - nearly all major OECD economies are facing high levels of public debt, recession and possibility of devaluation. The recession is as bad, if not worse, in other major EU economies.
  • The recent appreciation in the Pound shows the markets have some relative confidence in UK

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