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Tuesday, 24 October 2017

IFR Sovereigns 2010

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Sometimes markets are shaken by an event so seismic that everything else seems to fade into the background. Greece’s slide to the brink of bankruptcy was such an event. With the collapse of Lehman still so fresh in the mind, cataclysmic consequences do not seem so far fetched as they once did. Nobody had any illusions as to what the stakes were as the crisis unfolded. But perhaps that was ultimately an advantage, focusing the minds of the politicians and financiers. Although the problem has not been resolved – and there is still a possibility that Greece will be forced to default – the speed and scale of the response seems to have been appropriate, and the situation may yet be contained.

The implications of the crisis were felt across the financial markets, but perhaps nowhere more keenly than in the sovereign bond market, where the creditworthiness of countries has for so long been taken for granted. And this has been perhaps been the biggest change – a change that can be seen, optimistically, as the realignment of the sovereign sector with rational attitudes to risk. The crisis has reminded the markets that no loan arrangement is ever risk free, even if the borrower is a country. The plight of Greece has made investors think about what it says about other countries – be they economically comparable, for example Portugal, or larger countries like the UK. Given the pace at which Greece has fallen from grace, the markets remain uncertain whether this might be the beginning of a domino effect.

This opens up the most important debate arising from the crisis, which is how quickly highly indebted countries can pay back their creditors. The process is a minefield of risks. On one side of the path lie credit rating agencies, nervous investors, potentially spiralling debt costs and ultimately economic ruin. On the other, removing cash from the economy before any recovery has proved itself sustainable risks an explosion in unemployment, a collapse in growth, rising welfare costs and more economic ruin. Inflation and deflation hang above the heads of sovereigns, the two Swords of Damocles, with nobody sure which one will fall.

The episode has seen the mandatory flight to quality associated with such crises, and the biggest beneficiary of that, in the EU at least, has been Germany. The re-emergence of sizable spreads between Germany and the smaller countries in the eurozone has reignited the debate about the long term future of the single currency. Many believe the lasting consequence of Greece’s humiliation will be the defenestration of those economies seen to be dragging the others down. If correct, this will be a process that will take years to play out.

Financial Armageddon is no longer on the horizon, as it was in the aftermath of the Lehman collapse, and yet the developed world’s financial situation remains precarious and the financial path forward uncertain. How sovereigns answer the big questions of the day will have profound consequences that will continue to reverberate for generations to come.

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