Sovereign debt issues so far pale in comparison to problems with the U.S. financial system, but as the Burj Khalifa serves to remind, many countries took on debt for various purposes and not all the uses of those cash borrowings were economic. Ominously, just as with subprime mortgage debt, some investors are warning that the problems right now are merely the calm before the storm.
Goldman Sachs (GS), in a year-end client note, advised buying credit default swaps on Spanish government debt as one of the firm's top macroeconomic trades for 2010. Credit default swap buyers, in exchange for periodic payments similar to insurance premiums, receive a payout if the debt they are related to defaults. Goldman says that Spain has high levels of debt in both the public and private spheres, a lack of political resolve to bring spending in-line with revenues, and a financial system that seems to be hiding its problems (as previously noted by DailyFinance). Spain is a part of the "PIIGS" acronym, a kind of recession-counterpart to the "BRIC" emerging markets that also encompasses Portugal, Italy, Ireland, and Greece, a collection of countries that investors worry may not be able to repay all of their debts.
Chinese Economic Bubble
Hedge fund manager Jim Chanos of Kynikos Associates, a firm dedicated to short-selling, or profiting from the decline of stock prices, has been noted as publicly speaking about bubble-esque economic activity in China. The Chinese have utilized their own economic stimulus tools in an attempt to keep growth on track, but -- in a claim eerily similar to Dubai -- Chanos has said the Chinese government may encourage so much industrial overcapacity to be built that they will be unable to sell the output goods at an economic price.
If it seems unlikely that a government would be unable to pay its debts that is simply a consequence of a multi-decade period of benign economic conditions, according to a paper authored by Professors Kenneth Rogoff and Carmen Reinhart in early 2008. Describing their findings, Reinhart notes, "Serial default on external debt -- that is, repeated sovereign default -- is the norm throughout nearly every region of the world, including Asia and Europe." Defaults on sovereign debt are also not randomly distributed; there are clusters occurring every few decades going back to at least 1800 where at least one-third of the countries being studied were undergoing a debt default or restructuring. Sovereign debt defaults aren't different than residential mortgage defaults in that sense except as a matter of scale; if your neighbor is under water, it's more likely that you are too.
Bad lending decisions in all asset classes seem to come in bunches and uneconomic activity is a reality of life. When equity is used in a display of vanity (say, the tendency for billionaire tech executives to build an enormous yacht, only to promptly build a new one right away), the consequence is simply a reduction in equity. But when debt is used for uneconomic ventures -- which often take place when the government is involved in business decisions -- the consequences can be terrible for an entire country, because the debt doesn't disappear, although the monument to waste might be effectively useless. Both history and smart market observers caution about complacency in the sovereign debt markets and 2010 could be a year of reckoning as investors re-assess places that offer both return on, and return of, their capital.
James Cullen edits and writes at CollegeAnalysts.com. He is the vice president of the Boston College Investment Club, which owns GS, but has no personal position in stocks mentioned here.