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Sovereign debt: Not all nations are created equal

While sovereign debt has continued appeal, nations handle debt differently. Northern Trust outlines challenges faced by issuers and implications for the value of sovereign debt.

Within the sovereign debt market, each country faces unique as well as common challenges. From quantitative easing to austerity programs, the credit crisis and global economic decline have sharply outlined the different approaches nations have used to manage their obligations.

Sovereign debt issuers fall all along the risk-reward spectrum. Emerging markets often offer more attractive yields than established economies. But attractive yields are often a signal from the market, as highlighted by recent instability in Northern Africa and fears of contagion in the Middle East.

“Emerging markets’ yields offer extra returns for a reason, but investors often underestimate the extra risk,” says David Blake, director of global fixed income at Northern Trust.

Risk and reward
US Treasuries, in contrast, offer relative safety, if less attractive yields. Even in light of its recent economic woes, the US remains a powerhouse in the government bond marketplace. It is the single-largest economy and military power and one of the most developed, stable and long-standing democracies in the world.

This February, despite mounting concerns over the nation’s ratio of debt to GDP, ratings agency Moody’s Investor Services maintained its AAA rating on US government debt. Among the reasons cited by the agency were the stable outlook and the US dollar’s position as the world’s reserve currency, meaning investors can move in and out of the dollar at will.

There may be criticism over the dollar’s status as reserve currency, but many believe this is unlikely to change soon. “The world cannot easily turn its back on the dollar as a reserve currency for the simple fact that so many countries worldwide own trillions of dollars in reserves,” Pesci states. “There are few, if any, non-self-destructing ways of exiting those positions in the short-to-medium term.”

Europe, on the other hand, continues to feel the effects of the economic turmoil inside some of its member countries. Bond yields in debt-riddled Greece, Ireland, Italy, Portugal and Spain tend to spike higher when investors become concerned. Some analysts remain fearful that the European sovereign debt crisis will dampen the value of the euro in the long term.

Pesci says Europe in general, and peripheral European countries in particular (with the notable exception of Ireland), have the disadvantage of low economic growth due to internal rigidities most notably in their labour markets, so they are expected to lag behind others despite their potential.

Still, there are pockets of highly desirable, export oriented or geographically diverse companies within these countries. At the same time the case for improved flexibility becomes stronger by the day, as acknowledged by the recent reforms in the Spanish labour legislation.

“We expect Europe to emerge battered but alive after the ‘extend and pretend’ periods draw to a close and we move to more realistic, or rather more sustainable, permanent solutions,” Pesci says, referring to the European Financial Stability Facility.

The Asian situation
Emerging Asia and the developed world are highly interconnected by trade and investment, but some parts of Asia are suffering from woes similar to the US and Western Europe.

Asian countries with large, young populations are happy to produce goods or provide services to more advanced economies, often at a fraction of the cost. These countries encourage trade by ensuring that their exchange rates remain competitive, making investing locally more appealing.

They also encourage foreigners to invest in production capacity (outsourcing) and export back to their own countries, explains Bert Rebelo, senior investment specialist at Northern Trust in Hong Kong.

However, he says there is the risk of having too much of a good thing. “These Asian economies are in danger of becoming overheated just as the rest of the world is starting to pull itself out of recession.”

In addition, further real growth could be impeded by their less advanced levels of social protection. Rebelo notes, for example, that if the need for cooling down the economy arose, the authorities would have limited means as a result of restrictive credit conditions to ensure those affected by unemployment were properly protected.

This could prove a source of instability, potentially deterring decisive action by the monetary authorities.

Japan faces a particular set of challenges within the Asian context. Japan is a developed country with a mature population, similar to the “baby boom generation” in the US. Older populations have specific needs in terms of health care and other forms of support. Therefore the younger generations will be expected not only to shoulder the burden of the retiring generation, but also to ensure the existing national debt – already high by any standard – is duly serviced.

“This is a challenge for policymakers,” Rebelo says. “If Japan’s example is anything to go by, then  longer working lives, lower salaries and lower standards of living than those of the previous generations is what awaits most developed countries.”

He adds that this would be the case even without the substantial debt burden left by the previous generations.

Even before the March 11 earthquake and tsunami raised further questions about Japan’s financial situation, Standard & Poor’s downgraded the country’s sovereign debt rating to AA- from AA, citing political instability and expectations for the country’s fiscal deficits to remain high during the next few years.

If Japan’s government fails to reassure the rating agencies of the sustainability of its public finances, further downgrades will remain a real possibility.

The money supply
As the credit crisis unfolded, central banks worldwide made fresh funds available to avert a breakdown of their banking and payments systems.

“Over time all this extra liquidity comes with a hefty price tag, namely a lot more cash chasing broadly the same amount of goods and services,” Pesci notes “That invariably pushes prices up over the medium term.”

Cash injections by the US and other nations will be hard to withdraw without risking the fragile recovery, keeping commodities at relatively high levels for the foreseeable future, he adds.

Convertibility and transferability
Investors considering the lucrative local debt markets should try to ensure that they are either suitably hedged or ready to exit such markets once investment objectives have been achieved or the risk/reward profile no longer meets their investment preferences.

Investors interested in quickly industrialising parts of the globe should also be aware of the problems of transferability and convertibility.

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