Sovereign & Bank Debt – The Elephants in the Room

Sovereign debts, particularly Portuguese and Spanish debt, are the two large elephants in the room when it comes to international debt trading. It is almost unthinkable that a nation would default on its debt or obligations. Possibly one of the largest concerns is European sovereign debt and European banks.

Combined, Italy, Spain, Belgium, and Portugal will need to raise over $800 billion this year to cover rollover debt and new borrowing. Then there is Greece and Ireland. Belgium’s debt is reputed to be close to 100% of GDP. Belgium has gone for over 200 days without a parliament being able to be formed. It is a much divided country and has been for years, with parts being Flemish and other parts French.

One of the biggest threats is that of Ireland.Last year In the middle of the credit crisis, the Irish government guaranteed not only the deposits of Irish banks but their bonds. Irish banks, like Icelandic banks, were larger than the GDP of the country. A large percentage of the guarantees are to German, French and British banks.

Effectively the Irish taxpayers are not only bailing out their own banks, but banks all across Europe. To meet their obligations the Irish will need to pay about 10% of their national income, which amounts to between 30-50% of the Irish governments tax revenues. This means that the Irish government will either need to massively increase tax rates, or really slash government spending.

Public servants in Ireland who believe that they have job security will undoubtedly be in for a shock. If they can find insurance cover that covers redundancy, then they would probably be well advised to take out a policy. The chances are that 25% of public servants in Ireland may lose their jobs over the next few years.

Such a scenario is politically unsustainable and a massive public backlash is inevitable. Ireland has been told by the European Central Bank to reduce wages and costs. Ireland, while it does not have its own currency to devalue, has little choice.

Irish political polls indicate that the governing party, which cut the deal to increase the debt load by some 30% of GDP, will lose the elections, most likely to parties that are campaigning on repudiating that debt. If this happens, Irish bank bondholders could face a loss in the region of 80% or more.

A new ruling party, or more likely a coalition, will have a mandate to simply not guarantee Irish bank debt. Most of the losses would be to bond holders throughout Europe with its much larger population, rather than a relatively small number of Irish taxpayers. This would be particularly hard on the British as they may have around GBP 130 billion pound exposure to Irish banks. It could also severely impact on the Euro.

If this happens, we could be back to a similar situation when Bear Sterns and Lehman Brothers collapsed. That is interbank lending dried up. Fortunately the situation for New Zealand and Australasian Banks should not be as bad as several years ago as these banks are now sourcing a lot more of their funding from within Australasia.