Sovereign Debt, the new ‘Sub-Prime’? Robert McGarvey

You may have heard in the news recently of the debt crisis in Dubai. At issue is a potential default of the outstanding loans ($59 billion) of Dubai World, a state owned development entity situated in the prosperous Persian Gulf Emirate. The Dubai department of finance has requested a ‘standstill’ on all Dubai World debt repayment, particularly on bond payments due December 14th.

Unfortunately, although not technically a sovereign debt, Dubai World is perceived by its lenders (and may have been represented) as having the backing of the Government of Dubai. Sheikh Mohammed bin Rashid Al Maktoum the ruler of Dubai has however disavowed any government liability in the matter. Speaking to the press last week he said:  “this company (Dubai World) is independent of the government, they (international investors) do not understand anything”.

You may wonder what this has to do with your business, Dubai is a small micro state a long way away; unfortunately this in another of those ‘over the horizon’ problems that could come rebounding back to haunt us all. The Dubai World problem is not just a local problem; it raises unwelcome questions about the stability of ‘sovereign debt’ around the world, and that strikes fear into the heart of our present financial system, potentially threatening recovery in the rest of the world.   

The recent economic recovery (OK, stabilization) is very welcome for all, but it has been purchased in part by a massive government intervention in the economy. According to the Bank of England, state intervention ‘just to support banks’ in the UK, USA and euro-zone during the present crisis amounts to US$ 14 trillion and that, of course, does NOT include the trillions more of ‘stimulus’ spending that has taken place in all developed economies over the past 18 months. All of this amounts to a massive explosion in state indebtedness – sovereign debt.

Consider the following sovereign debt warning from Edward Harrison of Credit Writedowns:

From Dubai to Iceland, Ireland, Greece, Hungary, Italy, Portugal, Spain, Japan, France, the UK and the USA, the sovereign debt burdens have been at current levels during peacetime only on the way down from even higher public debt burdens incurred during wars.  Watching the public debt to GDP ratios rise to levels likely to reach or exceed 100 percent of GDP by 2014 is deeply worrying, especially with structural primary (non-interest) deficits as high as they are. 

How could this impact you at home?

Well consider that your local bank is just finally getting its self back in order after the financial crisis. It has finally cleared out all those nasty securitized sub-prime mortgage assets and other high risk derivatives, replacing them – at government request – with ‘rock solid’ government paper, particularly attractive are US treasury notes which are considered the world’s most secure investments, almost risk free.  

Today the capital base of many banks is stuffed with sovereign debt, and they therefore depend upon a continuing faith in the stability of those government debt assets -in fact the stability of the global financial system depends upon it.  

Having learnt the lessons of the past few years, however, banks are touchy these days.  Let’s face it, even AAA credit ratings are no longer simply assumed to be solid. So if market sentiment were to suddenly turn against sovereign debt, then the perceived value of the sovereign debt assets would diminish. In other words the capital base of most banks could take another hit. Heaven forbid that a larger state (California?) or government should default.

What will the banks do? Of course the banks would react (panic) – by jacking up fees and reducing exposure. Both of which could present serious problems for you – right here at home.

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