Unless you've been living under a rock for the past few years – which, with home repossessions in Spain at record levels, may not be quite as absurd as it sounds - you’ve almost certainly heard the term “European Sovereign Debt Crisis” being bandied about. It´s become a mainstay of financial commentator's parlance these days. Whether it's down to laziness or that they´re simply at a loss to explain why the Dow has fallen for the 7th session on the bounce, they’ll invariably wheel out the old gem “…due to continued uncertainty surrounding the European sovereign debt crisis.”
To be fair, it does sound like it could cause some havoc. If said with sufficient gravitas, a la Robert Peston, (the BBC Business Editor who has a penchant for stressing random vowels, accentuating the end of every sentence, and then spectacularly combining those two speech peculiarities with a hypnotically slow delivery) it´s an escape route out of almost anything you have trouble explaining. Give it a whirl yourself. Next time you’re in the shopping centre and one of those ING reps leaps out at you from behind a potted plant, armed with an orange clip board and an application form for a savings account, wave them away with furrowed brow and announce “I couldn´t possibly right now, due to continued uncertainty surrounding the European sovereign debt crisis.” And why stop there? Try it out on phone companies, insurance salesmen, telemarketers, annoying family members… ah but I´m starting to digress.
In this post I want to look at what a sovereign debt crisis is and explore how nations get in so much debt in the first place. Nations, just like people, take on debt for all sorts of reasons. To give you a crude example; we have 3 kids and could really do with an extra bedroom. With the housing market utterly stagnant there are basically two options open to us. We could apply for a loan and start building an extension next Monday, or, we could squirrel away a hundred euros every month for the next decade or two, and with any luck, just as the last of our brood are moving out to set up a home on their own and we´re finally in a position to think about down-sizing, we should have saved just about enough to construct that extension we no longer need. In a similar vein, so a government might have a transport infrastructure project that it needs to fund sooner rather than later. Perhaps there may exist an urgent need for additional social housing, new schools, prisons, hospitals… the list goes on. A sharp rise in unemployment can also mean that a government´s source of funding via income tax is affected, what´s more as it finds itself receiving less in tax contributions, so it has to pay out more in unemployment claims, but as long as the rise in unemployment is a temporary blip, a government can borrow to cover the shortfall. To fund itself for any of these reasons a government will issue bonds.
Very, very simply, a government bond is a financial instrument issued by a federal government or sovereign nation. It does this in order to borrow money over a period of months, a few years or even decades. The government will pay the buyer (bond holder) interest (usually twice a year) and because governments are in a position to raise or cut taxes, bonds are seen as a very safe investment and extremely low risk, especially amongst western developed nations. But I´ll come back to that in a minute. These bonds have a whole host of names but they are all essentially versions of the same things. Depending on maturity dates US Government bonds are referred to as Treasury Bills (T Bills), Treasury Notes or Treasury Bonds (T Bonds). Bonds issued by the UK government are known as Treasury Gilts, whilst the German issue is known as a “Bund”. But to reiterate, to all intents and purposes, whether it be a T Bond, a Treasury Gilt or a German bund they are all tools for monetising government debt – a way for governments to raise money.
So let´s say the UK government was keen to construct a high speed rail link between, oh I don´t know, London and, off the top of my head, let´s say Birmingham, but needed 32 billion quid to finance it. In order to get work started the Government might ask the Treasury to organize an auction of £5 billion worth of 15 year bonds. £5 billion is a fraction of the overall cost but more than enough to get work started and ensure there´s an army of steel toe-capped navvies marauding over the Chilterns. The auction would be advertised in the financial press and through the UK DMO website (Debt Management Office – an executive agency of HM Treasury) and private and instititutional investors would then be able to apply to purchase bonds. Earlier I alluded to the fact that government issued bonds are seen as a good, solid, low risk investment that offer a steady rate of return. Historically G7 countries have carried a Triple A rating which is an indication that a bond purchase from that country is a top drawer, guaranteed investment. AAA bonds are the bread and butter of well-managed pension funds, who spread risk over a variety of financial instruments. Nicolas Sarkozy made a good deal of noise about defending France´s cherished AAA rating, and one could be forgiven for thinking it was his sole raison d’être. He failed. Standard & Poor downgraded French debt a notch last week to Aa+ which cheered me up no end. To get an idea of a bond in action and to make absolutely sure we´ve nailed this T Bond / Bund / Gilt malarkey let us hypothesise. Let’s imagine that I, being the big ol’ softie that I am, an incurable romantic, decided to purchase for the wife a £200 holding in 3¾ % Treasury Gilt 2021 for her Christmas present last month. (I didn´t, she got a Bosch hand blender. Actually it´s for food but I bet it could really mangle a hand on a high setting.)
- 3¾ % tells us the coupon rate, the annual fixed interest payment that she will receive twice yearly on her holding. On a 200 quid holding that equates to £7.50 every year paid as £3.75 every 6 months.
- 2021 tells us when the bond matures, so this is a 10 year gilt. In other words over the next decade she will receive £7.50 each year and then in 2021 when the bond reaches maturity she will receive a further payment of £200 which represents my original investment. And then she´ll take me down the Broken Pencil for a beer.
This system has worked pretty well for centuries. Governments in command of tax revenues and interest rates can keep their borrowing under control and run something approaching a balanced budget. (Not necessarily balanced year on year, but with a surplus in good times that can cover a deficit in leaner times, and over the course of an economic cycle, generally balance itself out) I´ll come to the Nixon Shock, the abandonment of the Gold Standard and the move to fiat currency in future posts but for now, in order for us to get an idea of what constitutes a sovereign debt crisis, we'll turn our attention towards Greece.
It´s now widely accepted that Greece never met the entry requirements for acceptance to the Euro. A bit of creative accounting here, a bit of tippex there, “Ooooh did I add an extra 3 zeros to that statement? don´t you worry your confused little head about it, have some more ouzo, I´ll go and dig that tippex out again…” but discrepancies like that were overlooked and then buried in fanfare and celebration as the euro was launched; finally a potential reserve currency to rival the mighty US dollar. Overnight the Greek government went from paying double digit interest rates on the money it borrowed to paying a rate on a par with Germany - the economic powerhouse of Europe. Greece supports a huge welfare state and civil service. One could be forgiven for thinking that tax avoidance is compulsory, it isn´t, but it’s certainly rife. Greece consistently runs a budget deficit. The prestige of being a Eurozone member suddenly launched Greece into a world of cheap finance that it could never have dreamt of obtaining as an independent sovereign nation using the Drachma. Athens lacked both the fiscal discipline and the will to address the trend of running an ever larger deficit. The government, rather than implementing unpopular policies of a far more stringent tax regime on an electorate whose votes it would require for re-election, instead held bigger and bigger bond auctions in order to roll over its spiralling debts ; effectively borrowing from Peter to pay Paul, whilst all the time enjoying the lowest retirement age in the EU and a government job (sometimes two) for life. We´ve all read horror stories of the hapless shopaholic, who maxed out a store card, so took out a credit card to pay the store card, but found themselves crippled by the interest payments so took out another credit card to pay off the previous credit card… Think hapless shopaholic on steroids, think Greece. To give an indication of just how suspect the tax collection system is, it is worth noting that there are more owners of Porshe Cayennes registered in Greece than there are people declaring an income of 50,000€ or more per annum. Quite frankly it’s nuts.
Nuts.
With many institutions having taken huge hits on the whole US sub-prime episode in 2008 (something we´ll look at in the future) investors began to look very closely at just what bonds, equities and collateral they were holding on their books. It didn´t take long for them to conclude that Greek bonds were looking increasingly precarious, and so they systematically began to sell off their holdings, thereby reducing their exposure to any potential default. Of course once the word is out that Greece could be in trouble, investor confidence evaporates. Who in their right mind is going to buy a Greek bond when there exists the very real possibility of a default. As a result yields (interest the Greek government has to pay holders of its bonds) surged. As yields surged, so the Greek government had to pay more and more money to roll over its debt. A temporary spike in yields is not a disaster, but once a country finds that it has to consistently pay more than about 7% on its 10 year bond issues, the debt dynamics change. This morning the Greek Government 10 year benchmark bond opened with a yield of 35.11%, yes 35.11%. Contrast that with the German 10 year benchmark bund which opened this morning with a yield of just 1.82% and it starts to become clear just how much of a hole Greece finds itself in.
.jpg)
Greece - Pretty much buggered.
Clearly once yields are over the 10% mark countries find themselves effectively locked out of the markets, they simply cannot afford to pay rates that high. It is the equivalent of you or me trying to buy a house on a credit card at 22.9% APR; a 30 year €200,000 mortgage would cost us an eye-watering €3820 per month. Once a government can no longer raise money on the bond markets it becomes increasingly desperate. It has wage bills to pay, hospitals to run. Simply not paying government employees would result in anarchy, civil war, revolution. So in order to function it will raid public employee pension funds in order to pay the bills, it will look to sell state-owned assets; telephone companies, railways, ports and it will face the fact that it has to introduce massive austerity measures if it wants to avoid defaulting on its obligations. With this in mind it is worth keeping an eye out on ebay for a bargain; you might find the Elgin Marbles or the island of Skyros at an attractive price. It will also talk to the IMF, (International Monetary Fund) to arrange emergency funding (a bail-out) and will talk to holders of its bonds in an effort to restructure its debt. The IMF will arrive and scrutinize the accounts, and insist on various conditions being met before it releases any money. It will expect a firm commitment from the government that it will cut spending, reduce costs, raise (and collect) taxes and then money will be released in tranches based on certain criteria being met. The other option available of course is default. In the case of Greece it could simply refuse to honour its financial obligations. This would certainly mean expulsion from the Eurozone, meaning it would have to reintroduce its own currency. Trade embargoes would be implemented, political sanctions imposed; Greece would find itself in the political wilderness. However, there´s a valid argument that says after an initial period of adjustment, it could be the making of Greece. Free of the shackles of the euro and in control of its own currency, it could manipulate its interest rates, print money, devalue; it could become a competitive tourist destination once again.