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Rediscovering sovereign risk

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8 February 2010 12:55

After a major financial crisis that catches most people by surprise, you tend to see an increase (usually temporary) in sensitivity to future risks. That means analysts in 2010 are going to spend a fair amount of time trying to predict the next disaster.

A candidate that's receiving a growing amount of attention is the return of sovereign risk. Last year's events in Dubai are now seen as an advance warning of troubles ahead; the unfolding Greek drama is a more recent confirmation of the thesis. 

One interesting feature of this rediscovery of sovereign risk is the focus on developed economies, whereas traditionally sovereign risk was mainly about emerging (or submerging) market country risk. An indicator of this trend comes from the world's ratings agencies (themselves looking more than a little devalued by the GFC). 

Thus Spain, Iceland, Greece, Ireland and Portugal have all been downgraded by at least one of the major rating agencies over the past year. And both the UK and US have been warned that their AAA-ratings are at risk. Meanwhile, credit default swaps are sending the same message.

Some of this is specific to the particular problems facing a select group of euro-area economies and as such is bound up with the future of Europe's monetary (and fiscal) arrangements. But another big part of what's going on is the large increase in public debt and deficits that have been a byproduct of the GFC, due to financial sector rescue packages and other bailouts, fiscal stimulus programs, and recession-hit government revenues. The table below is extracted from a November 2009 IMF report and looks at the state of public finances in rich country G-20 member economies. 

Along with the eye-popping size of Japan's debt at one end of the range and Australia's much more comfortable position at the other, the table highlights the fact that the Fund expects the GFC to add on average more than 20 percentage points of GDP to rich countries' government debt burdens.

Increases in debts and deficits on this scale inevitably raise questions about governments' ability and willingness to pay. Gauging ability to pay largely involves thinking about debt sustainability issues, while willingness to pay is more about the political costs involved (lower government spending, higher taxes and voter tolerance for these things shift). Even for rich governments where the ability to pay debt is not an issue (which is most of them), the political consequences of this increase in debt are set to be a significant factor.

Photo by Flickr user warein.holgado, used under a Creative Commons license.

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