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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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2

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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3

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

1

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A big job ahead

13

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?

14

% 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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