More Sovereign Default Risk May Be On The Horizon

As the developed economies of the US and other countries continue to accumulate levels of debt not seen since WWII, the IMF has warned that there is the danger of higher interest rates and slower growth that could threaten global economic recovery. As the debt crisis in Greece demonstrates, unless other countries stop increasing their entitlement spending, it is only a matter of time before they, too, will have to take drastic measures to avoid currency devaluation. See the following post from Expected Returns for more on this.

From the Washington Times, IMF: Mounting debt threatens global recovery:

Historic levels of government debt in the developed world could throw the global financial system back into crisis and clear plans are needed to bring it under control, the International Monetary Fund said Tuesday.

In one of its first broad surveys since the recent recession gave way to renewed growth, the agency said that "sovereign risk" -- the chance that sovereign nations have racked up so much debt they won't be able to borrow enough money to pay their bills -- is now perhaps the central threat to the global financial system.

Governments in the United States and across Europe have accumulated levels of debt not seen since World War II as the recession crimped tax receipts, spending rose on entitlement programs, and emergency measures were put in place to support the economy.

The staggering debt levels in developed economies will be of concern in the years ahead. To put it plainly, it's time to pay the piper for years of debt accumulation. Investors will have to reasses whether current yields are justified in light of the risk of currency devaluation. Current yields are more a function of speculation and direct government intervention than fundamentals. In the end, fundamentals always win.

Gold at $1,140 dollars suggests that sovereign debt remains an issue for investors. The simple-minded will tell you gold is a bubble; the truth is, gold is the canary in the coal mine signalling sovereign debt concerns.

Interest Rates Rise, Death Spiral Begins

"The crisis has lead to a deteriorating trajectory for debt" among developed countries, which could cause higher interest rates and slower growth and weaken the broader financial system, the IMF said. Government debt could "take the credit crisis into a new phase, as nations begin to reach the limits of public sector support for the financial system and the real economy."

The most acute government debt problems are currently in Greece, whose government is negotiating a rescue plan with the IMF and other European nations but has already had to cut social benefits and raise taxes.

"Greece is a wake-up call" for the rest of the developed world, IMF's head of capital markets, Jose Viñals, said at a briefing about the report.

The debt crisis in Greece is just the tip of the iceberg. Time will tell if the Greek economy can recover with the austerity measures imposed upon them. If the potential bailout of Greece follows the pattern of previous IMF bailouts, then the Greek economy is in a lot of trouble. The Euro will come under pressure as the larger European economies follow the path of Greece to default. When Greek debt is trading hundreds of basis points above German debt, you have to start questioning the sustainability of the Euro.

The high yields on Greek debt underly how sovereign risks dictate interest rates, not increasing economic activity. Make no mistake about it: when long-term interest rates in America rise, it will be because of sovereign debt.

Americans should get used to the death spiral Greece finds itself in. Higher bond yields will redirect government revenue to creditors, which weakens the budget position of Greece. The Greek government will raise taxes further in a knee-jerk response, leading to more civil unrest and a stagnant economy. Global players will be searching for a complicated solution to this never-ending crisis when the solution is rather simple. It's called stop spending, stupid.

This article has been republished from Moses Kim's blog, Expected Returns.