Will 2009 be the year of sovereign defaults?

A sharp rise in sovereign spreads suggests this could be an alarming possibility.

On January 9, Standard & Poor’s announced that Greece, Spain andIreland were on review for a possible downgrade, indicating that aEurozone country could default. If financial crises have taught us onething, it is to take such “black swan possibilities” (as NicholasNassim Taleb would describe it) seriously. A sovereign default by asmall country could wreak havoc on the markets for credit default swaps(CDS) and might even destroy financial institutions in other Eurozonecountries. It could trigger panic rise in bond yields and the threat ofcontagion could turn into a self-fulfilling prophecy. A far moreserious threat would be a cascading series of defaults that wouldeventually include one or more of the Eurozone’s large countries.The 10th birthday of Eurozone seems to be holding out ominous portents.

Of late, sovereign CDS prices of the world’s rich nations haveincreased dramatically. In the past three months, the US FederalReserve has created more credit than it has ever done before. The sumof its earning assets, known in trade parlance as reserve bank credit,has grown at the outstanding rate of 2,922 per cent. The CDS price ofthe US has risen to a record 57 basis points in the face ofdeteriorating credit conditions of banks and non-finance companies andconcerns over the $1,000 billion it needs to raise in bonds to tideover the crisis. On similar grounds, the CDS on Spain, which like theUK and the US has seen its property bubble burst, rose to 106 basispoints, while that of France has risen to 56 basis points and Germanyto 43 basis points.

It now costs £110,000 to insure £10 million of UK debtagainstdefault over five years, or £50,000 more than it did in themiddle ofNovember 2008. The same cost £8,000 in February 2008. The rise isdueto concerns of the amount of bonds the government will have to issue tobail out the banks and stimulate the economy. The UK is forecast toraise £135 billion annually — three times more than in pastyears,until 2013. To add to the woes, the collapsing UK housing market willadd to the strain. Ironically, it costs more to insure the UK againstdefault than some of its major banks such as HSBC and Lloyds.

Italy’s CDS price is the highest amount the G-7 nations at 161 basispoints or ¤161,000 to insure ¤10 million of debt overfive years. Thereasons being that Italy’s debt/GDP ratio has escalated to 103 per centor the highest in the Eurozone. Among the highest sovereign CDS pricesare for Argentina (trading at 4,050 basis points) and Ukraine (tradingat 2,400 basis points). The economies of Latvia, Bulgaria, Ukraine,Pakistan and Iceland are being singled out as the most vulnerable andMoody’s has placed them on negative watch.

Greek bonds are trading at a significantly higher yield thanGermany, showing a perceived default risk. The spread of Greek bondsover German bonds is 2.32 percentage points, almost 10 times its leveltwo years ago. Spanish spreads have risen above 90 for the first timeas well. An Intrade prediction puts the odds on a current Eurozonemember leaving the euro by the end of 2010 at about 30 per cent. Themarket is nervous about other nations on the Eurozone’s periphery,notably Ireland and Spain, which got over-extended during the creditbubble. Argentina, Venezuela and Iceland have the highest default risk,with Russia not far behind. Germany, Japan and France all have lowerdefaults risk than the US at the moment.

In 2006, Pakistan issued a 30-year bond at a spread of just 300basis points over Treasuries. That is a very low level for a countrywith such poor economic fundamentals and a history of politicalinstability. Although Pakistan has not yet defaulted, their bonds tradeat about 40 cents on the dollar, suggesting that the likelihood ofPakistan defaulting is now imminent.

Other sovereign entities have already defaulted. The Seychellesdefaulted in August 2008. On December 13, 2008; Rafael Correa,Ecuador’s president, said his nation intended to default on its foreigndebt.

Fears have also mounted recently that Argentina will struggle tomeet its 2009 debt servicing payments of $21 billion, but economistsbelieve it will avoid defaulting, in view of the fact that the statewent so far as to nationalise private pension funds just to meet itsobligations.

As massive de-leveraging takes place, it leads to increased marketvolatility and absence of players from the credit markets. This is turnleads to various bond market dislocations.

For instance, over the past few years Russia (rated BBB) has beenrunning large deficits and has substantially more government debt as apercentage of Gross Domestic Product. On the other hand, Turkey hasbeen running large fiscal deficits and has relatively more governmentdebt as a percentage of Gross Domestic Product. Yet, on account of theanomalies mentioned above, Turkish dollar bonds yield a little over 8per cent, whereas Russian sovereign debt yields more than 11 per cent.

Emerging market debt spreads have yet to adjust fully to therealities of weaker global growth, falling commodity prices and higherdefaults. Historically, emerging market debt has traded on similarspreads to high yield as both have similar underlying credit quality.Yet, currently spreads on high yield are about 1,400 basis points widerthan emerging market spreads.

Many emerging market countries have weak fundamentals with severalcountries like Hungary, Ukraine and Pakistan are at the beck and callof the IMF. At current spreads, investors are not being fullycompensated for the risks in many of these countries.

High-yield spreads are above 2,000 basis points and still widening.This provides a premonition of how much emerging market spreads mightwiden, particularly the sub-investment-grade issuers.