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Sovereign Risk
Old certainties being replaced by new realities
Andrew Pease, Chief Investment Strategist, Asia-Pacific
Fiduciary Investors Symposium, Beijing
24 October 2011
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In economics, things take longer to happen
than you think they will, and then they
happen faster than you thought they could.
Rudiger Dornbusch
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The American Republic will endure until the
day Congress discovers that it can bribe the
public with the public's money.
Alexis De Tocqueville (?)
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Sovereign risk – what have we learnt?
Not just ability to repay, but willingness to repay
Determined by politics
Has been turned on its head
What was safe (G7) now looks a lot riskier
What used to be risky (EM) now looks a lot safer
Issues
Debt sustainability arithmetic
Can austerity be expansionary?
What to watch?
Do fixed income benchmarks make sense?
What is the “risk free” rate?
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About to head higher?
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Source: Reinhardt and Rogoff, This Time is Different, 2008
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US debt: pain ahead for someone
6
0
20
40
60
80
100
120
140
160
1940 1950 1960 1970 1980 1990 2000 2010 2020 2030
% of GDP
Source: Congressional Budget Of f ice
United States: Government Debt
projections based on current policies
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Which is riskier?
7
0
20
40
60
80
100
120
140
2000 2005 2010 2015 f 2000 2005 2010 2015 f
% of GDP
Source: International Monetary Fund
Gross Government Debt % of GDP
G7 countries
Emerging Markets
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Will G7 restraint be enough?
8
-10
-8
-6
-4
-2
0
2
2005 2010 2015 f 2005 2010 2015 f
% of GDP
Source: International Monetary Fund
Fiscal Balance % of GDP
G7 countries
Emerging Markets
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EM has the growth
9
-4
-2
0
2
4
6
8
1980 1985 1990 1995 2000 2005 2010 2015
World GDP Growth
Developed Emerging
%
Source: International Monetary Fund
IMF Forecasts
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Not all EM is the same, however
10
-7
-5
-3
-1
1
3
5
85 95 05 10 85 95 05 10 85 95 05 10 85 95 05 10
% of GDP
Source: IMF
Current Account Balances
All Emerging Markets Developing Asia Latin America Eastern Europe
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Lower risk at least partly priced in
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Source: Reserve Bank of Australia
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The painful arithmetic of debt stability
To stabilise Debt/GDP
Where
S = primary fiscal surplus
i = interest rate on public debt
g = growth rate of GDP
D = public debt to GDP ratio
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Dg
giS
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A big job ahead
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Gross
debt
Primary
balance
Overall
balance
Required
adjustment
between 2010
and 2020
Required adjustment
and age-related
spending, 2010–30
Austria 72.2 -2.5 -4.6 3.4 7.7
Belgium 96.7 -0.9 -4.1 2.8 8.4
France 82.4 -4.9 -7.1 6.3 7.9
Germany 84.0 -1.2 -3.3 2.3 4.6
Greece 142.8 -4.9 -10.4 15.5 19.0
Iceland 92.4 -2.5 -5.4 6.1 11.3
Ireland 94.9 -28.9 -32.0 12.0 13.5
Italy 119.0 -0.3 -4.5 3.1 4.1
Japan 220.0 -8.1 -9.2 13.6 14.3
Netherlands 63.7 -3.9 -5.3 4.4 9.7
Portugal 92.9 -6.3 -9.1 9.6 13.8
Spain 60.1 -7.8 -9.2 8.3 10.4
United Kingdom 75.5 -7.7 -10.2 9.1 13.3
United States 94.4 -8.4 -10.3 10.8 17.0
Average 99.3 -6.3 -8.9 7.7 11.1
Sources: IMF staff estimates and projections.
2010Primary Fiscal Adjustment to Achieve
60% Debt Target in 2030
Advanced Economies: General Government Debt and Primary Balance
(Percent of GDP)
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Would the United States of Europe be in crisis?
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% of 2011 GDP Euro area United States
Gross Public Debt 89 100
Net Public Debt 69 73
Primary Balance -1.5 -8.0
Overall Balance -4.1 -9.7
Current Account Balance 0.1 -3.1
source: IMF
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Beware of Greeks pretending to be German
15
-200
300
800
1,300
1,800
2,300
1992 1995 1998 2001 2004 2007 2010
basis points
Source: Datastream
10-Year Spreads to German Bonds
Spain
Greece
Ireland
Italy
Portugal
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Buckle up if Italian yields go over 6.5%
16
3.5
4.0
4.5
5.0
5.5
6.0
6.5
Oct-2006 Oct-2007 Oct-2008 Oct-2009 Oct-2010 Oct-2011
%
Source: Datastream
Italian 10-Year Bond Yield
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How to escape
Fiscal pain: higher taxes/lower public spending
Possible in a democracy?
Privatisation
Inflation
Inflation needs to be unanticipated
Need your own central bank & and local currency debt
Faster GDP growth
Can it be achieved with austerity?
Default
Bailout
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Can expansionary austerity work?
Fiscal austerity reduces GDP growth and taxation revenue
Expansionary austerity requires that private spending pick up
the gap
Lower borrowing rates could trigger higher spending
Bigger surpluses imply lower future taxes = more spending now
Needed – St Augustine to run fiscal policy
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Inflation risk?
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Source: Reinhardt and Rogoff, This Time is Different, 2008
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What have we learnt?
Old certainties can be quickly overturned
Sovereign risk is complex – it’s not DM versus EM
We can’t make naive assumptions about riskiness and risk-free
We need to watch the warning signs
Currency mis-management
Capital flows (current account deficits)
Asset price bubbles
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What to do as an investor
Active management
But managers manage to a benchmark
Benchmarks
Usually weighted by issuance – biggest loser
Fundamental indices an option (GDP weighting etc)
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I used to think if there was reincarnation, I
wanted to come back as the president or the
pope or a .400 baseball hitter. But now I
want to come back as the bond market. You
can intimidate everybody.
James Carville
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