The Return of Sovereign Risk in the Industrialised World

- "The severe deterioration of asset quality in the Western world’s banking system in late 2007 marked the opening act of the financial crisis. The second act of the crisis was the eye-watering drop in global economic activity during 2008 and early 2009, marking the start of the Great Recession. Yawning output gaps combined with falling asset prices and shrinking financial sector profits started to take their toll on public finances. Fiscal positions took a further hit when governments decided to embark on the biggest Keynesian experiment in living memory to prevent the repeat of the Great Depression 2.0. The “Great Rescue” paid off as the world economy has been tiptoeing back from the precipice since mid-2009. But now another danger seems to be lurking on the horizon – a wave of sovereign defaults in the industrialised world. The fear amongst many market participants is that this will mark the third act of this unforgiving crisis."
- "The fact that policymakers continue to remain divided about the timing of exit from loose fiscal policies only adds to investors’ concerns. It seems that we have learnt nothing from the rich history of financial crises. In one camp, policymakers claim that exiting now is necessary to calm market nerves lest interest rates will jump and turn the already bad situation into something far uglier. In the other camp, however, the opponents argue that synchronous exit of governments will do nothing more than strangle the incipient recovery at birth, which may weaken public finances even more."
- "The division between the two camps stems largely from their assumption of private sector recovery going forward. The “exit now” camp expects households and firms to step in as the government leaves the stage while the “exit later” camp believes that such assumption is grossly optimistic. Only time will tell which camp is right. But one thing is for sure, governments are navigating in unchartered waters. Relying too much on private sector strength can ultimately turn into an economic disaster if it proves to be incorrect (much higher unemployment and a paralysed banking system) while remaining complacent might push many sovereigns towards the brink of bankruptcy."
- "Given the amount of uncertainties surrounding both views, we decided to identify the industrialised countries that are most vulnerable to a sovereign debt crisis. In doing so, we look at a number of early warning indicators that have performed reasonably well in the past in predicting impending liquidity and solvency crises. Based on our Sovereign Vulnerability Index (SVI), Italy is the most vulnerable to a debt crisis after Greece mainly because of its strong reliance on foreign investors, relatively high level of corruption and high interest payments. The next countries in line are Portugal, Japan and the US. At the opposite end of the spectrum, the Scandinavian and current account surplus countries seem to be the least vulnerable."
Rabobank Economics Special July2010

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