The Trouble With a Sovereign Debt Crisis

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The trouble with a sovereign debt crisis is that you just never know what the tipping point is going to be. Things can be travelling along nicely with apparent stability and suddenly you find yourself in the middle of a crisis. For the last month we’ve been warning about a sovereign debt crisis in the Western Welfare states. After all, they are the ones (the U.S., UK, Italy, Japan) with high government debt-to-GDP ratios.

But we completely forgot about Dubai. It came up yesterday in conversation briefly with our colleague here in New Zealand under the topic: greatest misallocations of credit in history. We were talking about the wisdom of turning oil money into indoor ski slopes in the desert.

Today, however, we’ll be talking about whether Dubai could default on its debt. German, French, and British stock markets were all down over three percent overnight. The worry in markets is that Dubai could delay its debt payments. It would, according to Bloomberg, be the biggest sovereign debt default since Argentina in 2001.

Dubai World – the group that built an island shaped like the world – has $59 billion in liabilities. It has sought a “standstill” agreement from creditors. That includes $3.52 billion in bonds due on December 14th, which according to our calendar is in a couple of weeks or so.

Dubai World has assets all over the world. It has casinos in Vegas and banks in London and luxury goods stores in New York. Presumably it has assets it could liquidate to pay some of the debt. But there’s a lot of debt.

Bloomberg reports that Dubai borrowed nearly $80 billion over a four-year period. That borrowing – made possible in a way by the income stream from energy exports and rising energy prices – went straight into one of the worlds more impressive and outrageous property booms. But the bust has wiped nearly 50% of property values in Dubai and now this, the risk of sovereign debt default.

And suddenly the move into short-term U.S. Treasuries looks understandable, if not sensible. Emerging markets sold off on the Dubai news. And in the scheme of things, if you’re going to own sovereign debt risk at the moment, perhaps 90-day U.S. paper will cause you the least anxiety. It’s not a major commitment either (thirty years, for example).

How all this plays in Australia today will be interesting. We notice that Australian Small Cap Investigator editor Kris Sayce has trailing stops triggered on three positions over the last two days. Kris is taking profits on energy stocks mostly. The virtue of the trailing stop – other than turning a paper gain into a real profit – is that it makes the decision to sell a lot less emotional. If the stock hits your stop, you hit the sell button and take your money off the table.

However we’re assuming the selling momentum in the market will pick up. Wall Street managed to buck Europe’s negative lead. The Dow managed to close up for the day. And in the currency market, the greenback rallied against a whole basket of currencies, from the Vietnamese Dong to the Brazilian Real to the South African Rand.

That’s the kind of move – paired with the flight to sovereign bonds on the Dubai news – that could produce the dollar short-covering rally we wrote about several weeks ago. When so many people are short (especially with leverage) a short-squeeze can see huge moves in markets as investors and traders are forced to sell leveraged positions (emerging market stocks and high yield currencies) and repay their dollar loans before the currency gets much stronger.

Mind you, as we believe Voltaire once said, all paper currencies eventually reach their intrinsic worth. But between now and then, you might want to buckle yourself up for a powerful U.S. dollar rally. It will defy the fiscal and monetary fundamentals in America. But this market is not trading on fundamentals at the moment.

This mean’s the Aussie dollar’s march to parity against the greenback may be on hold. Even oil dropped off the pace a bit. Another round of global deleveraging would not bode well for economic growth, which would not bode well for oil. For now, only gold seems to be holding the line – perhaps because the demand for gold is not economic but monetary. December gold futures traded up over five dollars to $1,193.80.

Meanwhile, ominous sounds are coming from the U.S. banking industry again. The Wall Street Journal reports that in the third quarter, loans by U.S. lenders fell by the largest amount since the government began tracking such things. Loan balances fell by $210.4 billion, or 3%, according to the Journal.

This confirms the suspicion that banks aren’t lending…at least not to businesses and consumers. Banks are, instead, lending to the U.S. government via purchases of short-term U.S. bills and notes. We dispute the idea that it’s “risk free.” But it probably beats new mortgage lending by a good margin. And some banks – already struggling to stay solvent – wouldn’t be keen to put any more money at risk.

The Journal reports that, “The FDIC’s quarterly banking profile, which analyzed data from 8,099 federally insured banks, reported that 552 financial institutions, with combined assets of $345.9 billion, were on the government’s problem list at the end of September, up from 416 with $299.8 billion of assets at the end of June. That means roughly 7% of all U.S. banks are on the list and face a higher probability of failure.”

That is not a misprint.

It is, however, a warning. The GFC isn’t over. The FDIC story is about a coming American banking crisis. But it will surely affect global liquidity, which makes it an Australian story too.

The Fed began inflating the bond market a year ago with its planned purchases of Treasury bonds and agency debt. By telegraphing its intention to support bond prices, it fed the bond bubble. This pushed U.S. interest rates even lower, which made borrowing dollars to buy other things all the rage.

And 2009 has been all about the rage. Borrowed dollars have bid up assets all over the planet yet again. The debt side of the balance sheet has not been appreciably shrunk, meanwhile. Asset quality at banks has not notably improved. And national governments have actually gone the other way, expanding their liabilities to try and plug the spending gap in the economy left by the departure of consumers from the field.

Here we are at the end of the November, with the whole leveraged financial economy seemingly at another Lehman – like moment. The cost of insuring sovereign debt against default is rising in the Middle East. Investors are tallying up the year’s profits and deciding enough is enough. It’s time to sell and buy some gold and government bonds.

Is this a case of post-Lehman jitters? Is it a minor aftershock to the major temblors of the last two years? Or is it a sign of the “big one” to come? It’s hard to imagine financial events can get any bigger or worse than during the last few years. In fact, we can think of only one, the Great Depression. It’s beginning to look awfully familiar.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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17 Comments on "The Trouble With a Sovereign Debt Crisis"

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GB
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Hi Dan,
Another country that seems to have vanished from the debt radar is Russia. Russia had more debt going into the GFC than the combined debt of China, India and Brazil.

Their economy is still going backwards and banks aren’t lending. Could cause problems in the future

Coffee Addict
Guest
Assuming the USD drops by say 30% over 2010, a lot of the sovereign debt will vanish. Dubai may be off the hook if their close neighbour can keep them on life support until the USD tanks. The ultimate losers will be all creditors … be they the peoples Republic of China or the grandmother in your street with $20k in her cheque account. At this point in time I haven’t reached any firm conclusions on where the counterbalances in the economic plasticine are going to stick out. Debtor / creditor redistributions may be relatively neutral though changes in the… Read more »
prozak
Guest

**chuckle**
Dan, you mean the DOW bucked the trend on a day US markets were closed?

How surreal your world must be.

More classic investigative journalism from the DR

Dan
Guest
I recall the scene in the Australian film “The Bank” where the board of directors is put to vote for or against using a piece of software that can predict the movement of the stock market – there being a predicted crash in the coming days. They were told they could wipe out the competition in one fell swoop. All but one director (who walked out in disgust) voted in favour. The software was rigged to fail and the bank evaporated in hours. At least in that film there was ONE person who had the guts and the morals to… Read more »
Lachlan Scanlan
Guest

They almost get to inherit the earth Dan, but not quite. As per my reckoning of history. Meanwhile the real life TV show is amusing to say the least.

Ned S
Guest

71% of the planet is ocean. Water slops around and heavy valuable stuff like gold and diamonds sink to the bottom. That’s been going on for a while now I’d guess … Wonder when we are going to turn up the “jewel boxes” in the deep sea trenches? Not too soon I’d hope :)

Ned S
Guest

I’d rather own a house … :) :) :)

Ned S
Guest

In Australia where Komraad Krudd has assured me they’ll only ever go down significantly over the tax payer’s bled white corpse … :) :) :) :) :)

Fish are still doing well Lachie … To the point where I reckon I might have to let ma and pa eat their next brood! How’s ya bats?

Dan
Guest

Ned, sure you don’t want to swap your house for these magic beans I have in this here velvet pouch? Look how shiny they are!

Lachlan Scanlan
Guest
Kevy’s got a better job lined up ruling the world when hes finished running the arse end (quote Keating) of the world. Ol Penny though..never seems to smile much eh Ned. Kids had enough of bats now but enough fruit there for weeks yet. Just have to put up with their squarkin n carryin on. Tree frogs on windows and fifteen new ducklings the latest craze. Oh and re. fish…Ive seen some barramundi grown in small tanks in less than a year you could of fed several people with Ned. Gotta go feed cows now Ned….we had excessive rain here… Read more »
Ned S
Guest

Magic beans could be handy Dan – Can I eat them – Do you have a favourite recipe for preparing same?

Sounds like the kids are enjoying the good life Lachie! Barra hey – Might feed “ma and pa” to them! I’ve got a mate wants me to check out full on negatively geared investment houses for him here – Must admit in a saner world I’d probably warm more to your thoughts regarding good farmland though? The Saudis and Indians seem to agree – They are taking out long term contracts in places like Ethiopia …

http://www.washingtonpost.com/wp-dyn/content/article/2009/11/22/AR2009112201478.html

Lachlan Scanlan
Guest
Ned I want farmland to farm on and if I ever get it I wont be concerned about its future value because the investment angle is not what its about for me. Maybe you feel the same about your home which I completely understand. Investment/leverage/wealth management, is a means to an end but commonly we end up obsessed with the means and forget about the end. Interesting how I have to learn to make money so I can be a poor farmer. I think (for farmers, not so those in city/industrial status) farm land and water are more valuable than… Read more »
Dan
Guest

It could well be that, eventually, with the ETS some beurocrat in.. New York or Brussels is going to tell you what you’re allowed to farm, Lachlan. Chances are it’ll be grass and no animals.

Ned S
Guest

You’re a fortunate man Lachlan. I’m still not sure what I’d like to do when I “grow up”. Can think of plenty of hobbies of course. But fully suspect that if I did any of them professionally they just wouldn’t seem much like fun at all. What’s the old joke … Stop the laughter – You are at work – You are not supposed to be enjoying yourself! :)

Lachlan Scanlan
Guest

Horticulture is where I want to be (get back to) anyhow Dan but its hard to imagine the how we feed the world without the bovines. Putting one cow in the freezer makes for an awful lot of full tummies.

Coffee Addict
Guest
My general sentiment is that with all the low velocity, marginal momentum (fake) liquidity now pumped into the broader markets it may actually be incapable of deflating too quickly. The phenomena will not prevent volatile shifts between and within markets and asset classes. I think that we can accept that Dubai is sort of following in Iceland’s footprints. Unlike Iceland, Dubai’s governance structure and work ethic is pathetic. There will be a partial bailout and on this the markets may recover for a time. The likelihood of Abu Dubai bailing out Dubai World’s contractors is I think non existent and… Read more »
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