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Escaping the sovereign debt trap

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Standard Life Investments, the global investment manager, believes that few countries have the ability and policy responses to escape the approaching sovereign debt trap. Many OECD governments are suffering from the highest levels of national debt in a generation.

This reflects the slow economic recovery in recent years, affecting both taxation and spending trajectories, on top of any bank bad debts stemming from the Global Financial Crisis. The end result will be a sovereign debt trap, a state of affairs where the major debtor nations’ debt is unsustainable given current bond yields, their fiscal stance and growth outlook.

In the latest edition of Global Perspectives the leading investment house examines how these large debtor nations can escape such a trap, via growth and policy strategies that, if applied, allow these nations to escape the problems facing them. Not all nations are likely to be successful in this regard with major investment, economic, social and political implications. The report highlights that the danger for many highly indebted nations is a longer-term structural change downward in their growth outlook which will be difficult to reverse without dynamic growth policies combined with financial repression.
 
Richard Batty (pictured), Global Investment Strategist at Standard Life Investments says: “On current economic forecasts the stock of debt as a proportion of GDP is set to continue to rise in the developed economies but fall in the emerging economies in the years ahead. The maturity of debt matters. Of the big six debtor nations, four are likely to see up to a quarter of their debt roll over by the end of 2012. In some cases this will require emergency liquidity provisioning from their central bank. Sovereign debt problems in the years ahead are likely to relate more to Italy, Japan and, to a lesser extent, France. Investors are worried about potential defaults and credit rating downgrades which could induce a “buyers’ strike” especially while the nominal growth outlook remains weak as the high stock of debt crowds out the private sector. It is widely accepted that certain countries such as Greece will continue to taint sentiment regarding both Italy and France as co-members of the eurozone.

“Sovereign nations will escape the debt trap if they embark on the appropriate policies, including financial repression, to erode the real value of their national debt, plus growth strategies to raise trend GDP. Not all nations are likely to be successful.

“Our analysis of the economics of the sovereign debt outlook concludes that debt is unsustainable in four of the big six debtor nations. Only the UK and Germany have a fiscal, funding and growth outcome that should avoid a sovereign debt trap. While the metrics in the US appear worse, the fact it issues the world’s trading currency has so far placated investor concerns. Examining solutions to avoid a further sovereign crisis suggests the UK, US and Germany have an overall ability to engineer policies in aggregate to arrest a lurch into a debt trap. For France, the policy flexibility is more modest, opening up real risks. Italy, given the current debt metrics and policy inflexibility will struggle to avoid a liquidity and debt trap. Finally, it appears just a matter of time before Japanese debt requires a default risk premium, leading to much higher bond yields. In such a situation nations may be forced to extend the maturity of the stock of debt via a swap arrangement that effectively re-prices the existing debt burden, to the detriment of investors. This would have the effect of spreading the high liability of the state across a number of generations of the population, rather than just the present one.”

 

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