Spiralling Financial Contagion: Sovereign Debt Crises to Corporate Chaos?

London, UK - 5th February 2010, 00:10 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

Are Greeks bearing financial contagion gifts for the corporate sector as well? In a new twist, the debt crisis is spreading not just to sovereign issuers such as Portugal, Ireland, Italy, Greece and Spain (PIIGS) but it is also starting to hit their domestic corporate sector. In the corporate bond markets, the debt instruments of many corporations based in Portugal, Greece and Spain, in particular, are underperforming. This suggests that sovereign risk is coming home to roost. The domestic equity markets have fallen in double digit percentages in some of those countries over the last one month. Even if the governments in deepest trouble manage to formulate credible spending cuts, the record levels of unemployment may yet trigger mass labour strikes. Are the markets finally waking up to the contagion associated with sovereign debt risk and the intertwined private-public sector risks already flagged? Remember the five interconnected black holes mentioned in the ATCA briefing from late 2009:

1. China's quest to slow down its lending and the end of asset-bubble music;
2. Sovereign debt defaults and associated risk events with domino effects;
3. PIIGS impact on the Euro and Eastern Europe;
4. Japan's exorbitant debt to GDP ratio and its impact on the Yen; and
5. Commodities bubble in food, fuel and metal prices including oil and gold.

These concatenated risks may yet lead to a second phase of the global financial crisis via step-by-step contagion.

[ATCA Ref: II Phase of Global Financial Crisis? 5 Interconnected Black Holes]

Spiralling Financial Contagion

Sovereign Debt: Corporate Effects

There is rising concern that several governments will struggle to fund their budget deficits this year. European governments will need to borrow 2,200 billion euros or 3,100 billion dollars from capital markets this year to finance their budget deficits. This record issuance, in turn, will put pressure on public finances amid rising yields and volatility. To compound problems, additional short-term sovereign debt issuance —- which has to be rolled over once every three or six months —- will raise substantial refinancing risks for European governments, leaving them increasingly at the mercy of bond markets. An expected surge in issuance of short-term treasury bills in France, Germany, Spain and Portugal increases the market risk facing these countries -- most notably the exposure to interest rate shocks. Amongst Europe’s top issuers of sovereign debt this year, the major borrowers in aggregate will be:

1. France at Euro 450+ bn;
2. Italy at Euro 390+ bn;
3. Germany at Euro 385+ bn; and
4. The UK at Euro 275+ bn.

As a percentage of GDP, borrowing is expected to be the largest in Italy, Belgium, France and Ireland at about 25%. Recognising that the unprecedented record public-sector borrowing extends far beyond the PIIGS, the markets seems to be pricing in a widening array of sovereign downgrades.

The surge in the cost of insuring government debt against default is starting to affect domestic companies. Credit Default Swaps (CDS) have suddenly surged higher for a number of national champions based in PIIGS countries after having been unaffected by the rising cost of sovereign CDS during the last few months of 2009. The cost of insuring corporate debt especially in Portugal, Greece and Spain has also risen much faster than that of similar companies based in countries with stronger fiscal positions. Even British financial stocks have been led lower by significant percentages on concern of potential “contagion” from Europe’s sovereign debt crisis.

Euro Sinks, Dollar Rises

Essentially, what we are witnessing is a flight to quality. The Euro is sinking rapidly against the US Dollar as the cost of insuring not only Greek, but also Portuguese and Spanish, government and corporate debt has grown sharply. Investors are now concerned Greek problems will spread to other deficit-heavy economies across Europe, including some of the major powers, potentially forcing a slowdown in the economic recovery in order to bring budget deficits under control. This will severely impact the domestic corporate sectors in the affected countries. Most of the Euro-zone countries have to fund significant new debt issuance this year -- including Germany, France and Italy -- and the fear is that some smaller countries may not be able to attract buyers because of imploding public finances and spiralling deficits. That may cause failed auctions and default on debt payments.

Market Reaction

The market's reaction stands to logic as follows:

1. Governments may have been right to use their balance sheets in an attempt to reduce the impact of The Great Unwind (2007-?) and The Great Reset (2008-?);
2. Piling on sovereign debt may have alleviated the symptoms of the global financial and world trade crises;
3. However, massive sovereign debt may prove to be a temporary cure with huge side effects and many unintended consequences.

Moral of The Story

If highly indebted countries can't find a way of dealing with the consequences of The Great Recession, their problems will ultimately rebound onto their companies and citizens, as the PIIGS countries are now discovering and the others will soon find out.


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Best wishes

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