"Acquaintance: A person whom we know well enough to borrow from, but not well enough to lend to."
- Ambrose Bierce, U.S. author and satirist (1842 – 1914), The Devil's Dictionary
We must all be acquaintances of our respective governments, for they are borrowing from us indiscriminately. How long will investors put their faith in the ability of sovereign nations to repay their debt? Greece, Iceland and other countries in Europe are a reminder that sometimes sovereign risk can be just that — risky.
The table below shows debt to GDP levels for some of the major developed economies, some of the "less robust" European economies, and finally, the BRIC nations. With the exception of Japan, which has had record government deficits and debt levels for the past couple of decades as it tries to work its way out a prolonged slump, the other major economies are fairly tightly bunched and the numbers generally look fairly manageable. There are a couple of caveats, however: most debt-to-GDP ratios have gone up sharply in the past two years, from the 60 percent level to around 80 percent and with inflation expectations on the rise, real bond yields have actually fallen despite the recent rise in nominal yields.
The situation facing Greece and the rest of the "PIIGS" (Portugal, Italy, Ireland, Greece, and Spain) is well documented and the numbers tell the tale — the debt-to-GDP ratio is up sharply in all cases, and were it not for the protective mantle of the euro and the European Union, problems would be even worse.
By comparison, the BRIC nations look somewhere better, even though India’s debt burdens are somewhat higher. Bond yields are higher in general as well, but that is largely a function of faster growth and higher levels of inflation.
Debt Levels & Bond Yields
||Debt as a % of GDP
||10-Year Gov’t Bond Yield
Sources: World Bank, OECD, IMF and European Union
As the chart below indicates, the euro has clearly paid the price for Greece’s woes and the looming problems in other parts of Europe in recent months, while the pound remains pressured by Britain’s fiscal and political woes.
However, for others, there appears little direct correlation between debt burdens and currency strength. Indeed, Japan’s debt to GDP ratio remains the highest among the G7 and higher than most other countries as well, but the yen remains strong. The Canadian dollar is strong as well, but in this case Canada’s fundamentals support currency strength.
The takeaway seems to be that current and even future debt burdens don’t appear to be a consistently reliable predictor of currency movements at present. That is not a complete surprise, as many factors play a role in currency movements on a day-to-day basis and most are short-term in nature. However, if these debt burdens keep growing (and they are already significantly higher than the 2009 Q4 indications above), will there come a time when the heightened risk of sovereign default impacts currency strength? The reasonable answer is yes and the euro bears that out. The dollar could follow that path as well, as many fear it ultimately will. Bear in mind that these are federal debt numbers – add in state, local and quasi-governmental debt and the numbers are exponentially larger.
However, what might precede currency weakness, in many cases, is a rise in bond yields, as lenders demand a larger risk premium for lending to increasingly worse credits. Once again, that has happened for Greece, though the impact has been cushioned for the rest of Europe because of the relative stability of Germany and France. U.S. yields have risen as well, though not particularly significantly, nor is it possible to point to rising debt burdens as the culprit with certainty. That could change if global investors reevaluate and re-price the sovereign risk of the world’s largest borrower.
If we accept that debt burdens will have an impact sooner or later, then perhaps some of the more fiscally responsible emerging market currencies could be a port in the coming storm. While China has refused to let the renminbi appreciate, the Russian ruble, Brazilian real and Indian rupee have all appreciated in recent months as the charts below indicate — and there may be more gains in store for all three currencies.
It is possible that rapid global growth could bail out these sovereign nations and avert a crisis. That appears unlikely at present, given the anticipated tepid pace of future global GDP and demand growth. Governments are likely to feel obliged to keep the spigots turned on, perhaps with positive short-term results, but less attractive longer-term outcomes.
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