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When the Ultimate Refuge Turns Risky

Satyajit Das

(Bloomberg Opinion) -- Until the financial crisis of 2008, government bonds were the traditional haven for investors. More than a decade on, their nature has fundamentally changed. In any future crisis, sovereign debt will be a propagator of risk rather than a refuge.

Government debt has reached levels not seen outside of major wars. In advanced economies, it has risen to more than 100% of gross domestic product, from around 70% before 2007. The increase is the result of governments taking debt on to their balance sheets to finance bailouts of vulnerable financial institutions, and of deficit spending to prop up growth. Domestic government bond portfolios are large relative to banking system assets in Japan and several countries across Europe.

Despite record low interest rates and purchases by central banks, the risk of losses on these supposedly safe securities is increasing. Once purchased for risk-free returns, government bonds now offer return-free risk, as James Grant, editor of Grant’s Interest Rate Observer, has quipped. Today, investors buy equities for income and bonds for capital gains, David Rosenberg, chief economist at Toronto-based Gluskin Sheff + Associates Inc., has said. That’s a striking reversal of financial logic, which says that stocks should be the riskier investment.

The danger isn’t increases in official interest rates, which are likely to remain low for a prolonged period, or inflation, which is still benign. The problem is the perceived creditworthiness of countries. A downward re-rating of a nation’s ability to pay its debt threatens sharp rises in yields and accompanying declines in bond prices, along with a depreciation in the currency. The ability of a sovereign to print money to service debt doesn’t alter this dynamic. Investors may be unwilling to hold a nation’s debt when there is concern about financial solvency or currency stability.

The primary channel for risk is the complex linkage between the rapid buildup of government debt and its effect on holders. Domestic banks are obliged to hold these securities for prudential reasons, while local and foreign investors buy them as a safe asset or as collateral for borrowing or derivatives.

This is how the feedback mechanism works: Rises in sovereign yields and losses on existing holdings create selling pressure, driving prices lower. Higher rates for governments, which are the foundation of credit costs for all borrowers, then flow through into increased financing expenses for consumers and businesses. A deterioration in sovereign credit ratings drives downgrades for all entities based in the nation, further raising debt costs. 

Losses on government bonds hurt the credit quality of holders. Over time, higher borrowing costs or tighter liquidity prompt increased defaults and nonperforming assets, undermining the health of the financial system. Selling by foreign investors puts additional pressure on bond prices and the currency. Cross-asset contagion is likely, as market participants who use government bonds as collateral need to raise funds to cover declining values. Investors sell equities and the currency.

As the availability of credit to banks and financial institutions shrinks and its cost increases, the beleaguered government is forced to support them to prevent financial distress, by recapitalizing entities or guaranteeing deposits. Higher debt levels and government contingent liabilities exacerbate the crisis.

Secondary channels, which operate with time lags, spread the problems into the real economy, affecting growth and employment. The major mechanism is tightening credit as losses reduce banks’ capacity to lend. A further issue is the loss of the value of savings. The ensuing downturn causes household and corporate incomes to fall. That reduces their ability to service debt, resulting in successive rounds of accelerating nonperforming loans and bad debts.

Meanwhile, slowing economic activity drives up fiscal deficits as tax collections fall and spending on “automatic stabilizers” such as unemployment benefits increases. The government’s financial position and flexibility deteriorate. At the same time, bank and investor weakness makes it increasingly difficult for the government to find buyers for its debt.

This process, seen in the 2011 European debt crisis, is reversible. Traditionally, after wars when government debt spiked, budget surpluses allowed rapid deleveraging. National debt-to-GDP ratios of the U.S., U.K., Australia and Canada more than halved between 1945 and 1955. Key facilitators were high GDP growth driven by post-war reconstruction, pent-up demand for consumer goods, wartime savings, favorable demographics, and high productivity growth.

Conditions today are fundamentally different, though. Increases in government debt to maintain economic activity are probable. Policymakers find themselves trapped and approaching the point of no return. It is ironic that actions taken to preserve the system and a key instrument — government bonds —  now pose a key threat to financial stability.

 

To contact the author of this story: Satyajit Das at sdassydney@gmail.com

To contact the editor responsible for this story: Matthew Brooker at mbrooker1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Satyajit Das is a former banker and the author, most recently, of "A Banquet of Consequences."

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