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New Normal:Unstable Financial System (cont)

December 31, 2010

Given that the global financial system is under enormous and growing stress let’s consider an increasingly likely scenario – a sovereign debt crisis – and follow a possible course of events to determine how such a crisis could affect your business.

To recap the brutal reality, the debt crisis is global and present levels of sovereign debt are unsustainable. When sovereign debt approaches a critical threshold (generally 80%) of GDP red flags are raised, bond markets and rating agencies start to get nervous. Now let’s examine the situation. Although Ireland, Greece, Portugal and Spain gather all the headlines today, the sovereign debt crisis extends far beyond these nations. Consider that ALL European nations, including Germany exceed their own legally defined limits of sovereign debt. But the Europeans actually look pretty good compared to Japan’s fiscal woes. Japanese government debt is set to top 200 per cent of GDP as their government bond sales exceed tax revenues for a third consecutive year. Even the United States, the world’s largest economy is in the ‘red zone’ with government debt levels approaching 97% GDP (2010 US GDP was $14.4 trillion). The figures are dazzling, consider that the US daily shortfall in 2010 was $4.27 billion – China alone purchased just under a $billion dollars of US Treasuries a day.

The other thing to remember is that the economy has become dependent upon low interest rates, which exist as a result of government and central bank intervention (quantitative easing etc). It is guaranteed that rates will rise and rise rapidly if bond markets lose faith in the ability of governments to manage their debt loads. For instance, when Greece got in trouble recently, rating agencies downgraded their sovereign debt and bond yield curves started to rise – in other words the market’s perception of risk was almost immediately factored into the cost of Greek government debt, which increased the cost of government and private borrowing, forcing the EU (read Germany) to intervene to prevent Greece tripping into recession.

A Possible Scenario

Let’s speculate, for example, with one of the main ‘trigger’ economies, Ireland. Pure speculation of course, but let’s assume that the Irish government’s financial restructuring plan lacks the discipline that bond market’s demand. In the late spring of 2011, for instance, Ireland begins to experience real social pain; Irish unemployment grows rapidly, tax revenues fall, austerity measure lead to progressive unraveling of the social safety net as schools and other public services close or are shut down. By September the public revolts and there’s rioting in the streets. The government facing enormous pressure begins to slip off its austerity plan, markets react with rolling downgrades of Irish debt, borrowing rates rise sharply tipping Ireland into a deeper recession.

By March of 2012 the burden become overwhelming and the government concedes, defaults on its debts, sending international bond markets into turmoil. This panics financial markets and stock markets fall sharply as investors scramble to readjust. The perception of risk and therefore the cost of sovereign debt rises on all Euro sovereign debt (which was thought to be safe). This rise in rates causes the suffering citizens of Greece, Portugal and Italy to come under increased pressure. They are asked to make further sacrifices to meet the needs of bankers and bond holders: they in turn rebel and default on their debts. Then the Euro collapses when Germany, overwhelmed by the scale of the problem, fails to bail out its partners, launching a major global financial panic.

The dominoes start to fall: interest rates rise globally, as governments – at their tax limits continue to be dependent upon private debt financing.  The US government, in particular suddenly faces a world with no demand for its paper at its preferred rates. The result is inevitable, with much higher perceived risks, the financial auction is on and T-bill yields move from historic lows of today, around 1-2%, to 10 – 20%, bank interest rates follow and the economy (which is now dependent upon low rates) reacts like it got hit by a train.

No one is prepared. Its 2008 all over again, except there’s no government bailout this time. Bankers panic, lines of credit are pulled, projects are canceled, or postponed until business can see where this is going. Businesses of all kinds go bankrupt or into hibernation, people lose their jobs, then their savings and finally their homes.

And this is only one of four or five ‘causal’ sources including the bursting of the China resource bubble, which would have similar effect.

None of this needs to happen, of course, if everyone keeps their cool. But keeping cool is exactly what does NOT happen in these situations.

Things to Think About

This is speculative of course, not preordained, but given the state of the global economy and the numbers, something like this is very likely to occur within the next five years.

  1. Improve your Situational Awareness, most people today are finally starting to relax, they’ve come through the recession of 2008, business is returning to normal and, as far as they can see no storm clouds are on the horizon.  However, like Jim Elzinga’s young climbing partner in the Rockies, (see blog post below) inexperienced managers misread the situation because they simply aren’t aware of the dangers or don’t know where to look for the warning signs. Do not delay, get more informed and better prepared NOW.
  2. Develop your options, you have a plan and now is the time to stress test it for disruptive changes. Where necessary develop disaster plans with tactical implementation worked out in detail and practice them – remember fear and panic will cripple your organization’s ability to act in a crisis situation – it’s why we do fire drills.
  3. Never forget the old adageflexibility is priceless in a crisis

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