Déjà vu

Sovereign Debt Crisis

OMAC Breakfast3rd Quarter 2010

The only man who sticks closer to you in The only man who sticks closer to you in adversity than a friend is a creditor.  adversity than a friend is a creditor. 

Author Unknown Author Unknown

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Sovereign Debt

Government borrows money externally and internally using bonds

ExternalExternal

InternalInternal

Foreign CountriesForeign BanksForeign CompaniesForeign Currency Bonds

Local CompaniesLocal InvestorsLocal Currency Bonds

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Creditors

Other Countries Foreign Currency Bonds Euro-bond

Companies Treasuries

Pension Funds Bonds, Index-Linked Gilts

Individuals Fixed Interest investments, Retail RSA Bonds

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Credit Risk

Not being able to pay your debtsNot being able to pay your debts

Company

Declared bankrupt

Legal framework protects creditors

Debt has determined seniority

Country

Can’t be declared bankrupt

Sovereign – no legal framework holds

Debt restructuring program with IMF involvement

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Sovereign Debt

Public Debt as a Percentage of GDP (2007)Source: CIA World Book

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Sovereign Debt

Ranking of countries by comparing sovereign debt to country GDP

South Africa ranks 87th with a debt at 29.5% of GDP

60% or less considered prudent

Rank Country % of GDP[1]

1 Zimbabwe 282.60

2 Japan 189.30

3 Saint Kitts and Nevis

185.00

4 Lebanon 156.00

5 Jamaica 124.50

6 Italy 115.20

7 Greece 113.40

8 Singapore 113.10

9 Iceland 107.60

10 Sudan 103.70

11 Belgium 97.60

12 Sri Lanka 86.70

13 Egypt 80.10

14 Israel 78.40

15 France 77.50

16 Hungary 78.00

17 Portugal 76.90

18 Canada 75.40 19 Germany 72.10

20 Malta 69.40

21 Austria 69.30

22 United Kingdom 68.10

23 Kenya 66.70

24 Jordan 64.40

25 Seychelles 63.20

26 Nicaragua 63.10

27 Netherlands 62.20

28 Cote d'Ivoire 61.90

29 Norway 60.60

30 Brazil 60.00

31 Mauritius 58.70

32 Philippines 58.70

33 Albania 58.10

34 India 58.00

35 Bhutan 57.80

36 Ireland 57.70

37 Uruguay 56.60

38 Cyprus 56.20

39 World 56.00

40 Ghana 55.20

41 Morocco 55.10

42 United Arab Emirates

54.00

43 Malaysia 53.70

44 Vietnam 53.70

45 Spain 53.20

46 Tunisia 53.00

47 United States 52.90 48 El Salvador 52.70

49 Argentina 48.60

50 Croatia 46.80

Public Debt as a Percentage of GDP (2009/10)Source: CIA World Book

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Boom to Bust

Countries borrow in order to finance further growth Capital projects like infrastructure

Lending happens in booms 8 lending booms since 1820s Most recent was in 1990s to Latin America, emerging Asia

and former Communist countries Credits include USA, Japan and Western Europe Driven by political change or new investment

opportunities

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Boom to Bust

All lending booms so far have ended in some countries going bust

Busts can be triggered by Deterioration of the terms of trade of debtor countries Recession in the core countries that lent capital Rise in international borrowing costs Crisis in a major debtor country that spreads globally Change in government or regime

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Boom to Bust

Examples

The 1920s lending boom turned to bust after in the 1930s after the collapse of commodity

prices and a recession in the USA led to sovereign debt defaults

Over-lending in the 1970s went bust after high interest rates in the USA combined with a

recession in 1980 to 1984

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Sovereign Defaults

In the last 35 years, how many countries In the last 35 years, how many countries do you know that have either defaulted do you know that have either defaulted

on or significantly restructured their on or significantly restructured their sovereign debt?sovereign debt?

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Sovereign Default

Russia

Argentina

Poland

Romania

Serbia

Ukraine

Turkey

Bolivia

Brazil

Chile

Cuba

Ecuador

Grenada

HondurasMexico

ParaguayUruguay

Angola

Cameroon

Cote d’Ivoire

Egypt

LiberiaMadagascar

Malawi MoroccoMozambique

Nigeria

Tanzania

Uganda

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Sovereign Default

IMPACTS

Reputational Costs Greater spreads on international debt More expensive to raise debt in foreign markets

International Trade Exclusion Cost to domestic economy Change in government, finance minister

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Sovereign Default

REMEDY Adjust economic policies

Taxes Management of budget deficit Structural imbalances

Emergency interim funding IMF plays a key role

Restructure of existing debt Longer term viability Often led by IMF review

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“Many citizens were stocking up for bad times and throughout the country shop shelves were being

emptied, leaving a shortage of even the most basic items, such as vegetable oil, sugar or washing

powder.”

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Case Study I

From Russia with LoveFrom Russia with Love

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Background

Artificially high exchange rate due to pegged

currency

Expensive Chechnyan war ($5.5bn)

Main exports ofOil, petroleum, natural gasMetals and timber made

Russia vulnerable

Asian Financial Crisis

Drop in Demand and Prices for crude oil & non-ferrous

metals

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Start of Crisis

Political crisis:Prime Minister fired

Cabinet reshuffle Interest rates hiked massively to attract foreign

investment(GKO at 150%)Debt on wages grows –

impacts major budget items World Bank and IMF

$22.6bn package approved to swap GKO for Eurobonds

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Into Crisis

Currency still fixed

Miners go on strike over unpaid wages, blocking Trans-Siberian railway

Monthly interest payments exceed tax receipts by 40% Left-wing government

elements reject government’s crisis plan – another cabinet reshuffle

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Russian Crisis!

Investor confidence evaporates and they flee

market

Government spends $27 bn to maintain pegged ruble

Stock, bond and currency markets collapse on fears

of default and ruble depreciation Stock market loses 75% of

valueBond yields at 200%

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Impact of Crisis

Ruble unpegged and moves from 6.43 to 21 ruble / Ruble unpegged and moves from 6.43 to 21 ruble / dollardollar

Inflation reaches 84% in 1998Inflation reaches 84% in 1998 Many Russian banks collapse as a resultMany Russian banks collapse as a result Local food doubles in cost, imports quadrupleLocal food doubles in cost, imports quadruple Massive demonstrations in many citiesMassive demonstrations in many cities Cabinet reshuffleCabinet reshuffle Ultimately, Boris Yeltsin resigns as Russian PresidentUltimately, Boris Yeltsin resigns as Russian President Surrounding economies in the region slow down Surrounding economies in the region slow down

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Recovery

Recovery in oil prices gives Russia a speedy recovery Budget surpluses in 1999 and 2000 allow debts to be

repaid Domestic industries benefit from devaluation of the

ruble Real economy still highly dependent on barter, so

more resilient to monetary crisis Social and political upheaval contained

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Case Study II

Don’t Cry For Me, ArgentinaDon’t Cry For Me, Argentina

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Background

1991Argentine pesos pegged to

the US$

1997East Asian financial crisis

1999Brazil devalues currency, hurting Argentine exports

Mid 1990s:US$ appreciates leading to budget deficits in Argentina

1998Russia, Brazil and finally

Argentina move into recession

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Start of Crisis

1999Political change:

UCR replace the Peronists2000

IMF $7.2bn aid package announced, based on

economic performance targets

2000Government announces budget cuts to restore economic confidence

2001Poor economic

performances leads to a further $40bn assistance

package from IMF

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Deeper Into Crisis

2001Minister of the Economy

resigns 2001

Voluntary debt restructure 2001Massive strikes over

government austerity measures and lack of economic confidence

2001Peronist opposition gains

control in mid-term elections

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Argentine Default!2001

Investor confidence evaporates and there is a

run on the banks 2001Supermarket looting

begins, nationwide strikes continue 2001

President and Finance Minister resign. Unstable

leadership in government 2002

Debt converted to pesos (devalued) and finally

foreign debt payments stopped

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Impact of Crisis

Argentina default on over $100 billion of debt, the Argentina default on over $100 billion of debt, the largest default in historylargest default in history

Peso devalued quickly as foreign investment left the Peso devalued quickly as foreign investment left the countrycountry

Pension savings (both local and foreign) lost Pension savings (both local and foreign) lost Peronist party back in powerPeronist party back in power Surrounding economies slow down Surrounding economies slow down Debt restructure still on going, but significant Debt restructure still on going, but significant

payment to extinguish IMF debt ($9bn) made in payment to extinguish IMF debt ($9bn) made in 2006 2006

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My Big Fat Greek…Default?My Big Fat Greek…Default?

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Background

2000 - 2007Greek economy one of

fastest growing in Eurozone

2000 - 2007Deficits used to fund public sector jobs, pensions, social

benefits

Mid 2000sEven in Eurozone, lower interest rates for Greek debt allowed deficit to

continue

2000 - 2007Flood of foreign capital allows large structural

deficits. (>100% of GDP)

Mid 2000sGreece could devalue

currency to limit impact of deficit

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Start of Crisis2008

Global financial crisis impacts tourism and

shipping heavily2009

Budget deficit revised from 6% to 12.7% after

consistent misreporting revealed

2010Budget deficit hits 13.6%, one of the highest in the

world 2010Debt hits 120% of GDP.

70% of debt held externally

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Euro Crisis

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Deeper Into Crisis2010 (Apr/May)

Greek government debt downgraded to “junk”

status 2010 (Apr/May)Yields on debt shoot to

15.3% 2010 (Apr/May)Stock markets worldwide

fall on fears of 30% to 50% haircut on Greek default Greece unable to devalue

currency

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Greek default…averted!2010 (March)

Greek government plan austerity measures and

request aid funding

2010 (May)Euro 110 billion loan deal

between Greece, Eurozone and IMF 2010

Strikes and rioting in response to austerity

measures

2010 (May)European Central Bank guarantee Greek banks’ access to cheap central

funding

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Impact of Crisis

Rapid provision of funding averts defaultRapid provision of funding averts default Creation of the European Financial Stability FacilityCreation of the European Financial Stability Facility Harsh austerity measures … “the party” is over in Harsh austerity measures … “the party” is over in

Greece Greece Social instabilitySocial instability Austerity measures for other EU member states Austerity measures for other EU member states Concerns that crisis could spread to rest of Concerns that crisis could spread to rest of

Eurozone leads to market volatility and pressure on Eurozone leads to market volatility and pressure on the PIGSthe PIGS

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Why Different This Time?

The bigger concern in Euro crisis was risk of contagion Contagion means debt crisis in one country worsens or

leads to a debt crisis in other countries Contagion can also affect banks and their debt

Banking System

Sovereign Debt

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Contagion Risk

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Contagion

Greece only 2.5% of Euro GDPGreece only 2.5% of Euro GDP

Portugal, Ireland, Spain, Italy and even UK vulnerable given Portugal, Ireland, Spain, Italy and even UK vulnerable given high budget deficits and debt to GDP ratioshigh budget deficits and debt to GDP ratios

Greek default would haveGreek default would have Threatened EU states reputationThreatened EU states reputation Destabilised the Euro as they exit the EUDestabilised the Euro as they exit the EU Threaten debt held by EU nationsThreaten debt held by EU nations Which could have had a knock on effect, leading to more defaultsWhich could have had a knock on effect, leading to more defaults

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Longer Term Implications

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Longer-Term Implications

Contagion risk has been contained (for now) with bailout and ESFS

But at a great cost: Austerity measures means populace pays for the debt

mismanagement Countries still borrowing to put together bail-outs and

rescue packages, which will put pressure on their economies

Political and social instability due to austerity and debt mismanagement

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Long-Term Implications

Implications for economies & citizens Structurally slower economic growth ahead as fiscal policy

is tightened Implies structurally higher unemployment & higher

dependency ratios It likely also implies structurally low investment returns A key focus of fiscal tightening was cutting state financed

social benefits, & cutting state financed pension benefits Calls to raise retirement age to 70 (from average of 61

currently) as pension funds seen as highly vulnerable to collapse

Source: Rian le Roux, Chief Economist - OMIGSA

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Bottom line for affected households Government’s budget constraints imply people must come

to expect the bare minimum social benefits in future As years (decades?) of fiscal consolidation lie ahead for

many countries, people will be increasingly be forced to provide for their own retirement

Likely structurally low investment returns will require a very high level of savings for those on DC funds, DB members face stagnant pensions

Have we really fully realised implications?Source: Rian le Roux, Chief Economist - OMIGSA

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Long-Term Implications While we are fiscally better off …

Deficit reduction / control will also have priority i.e. Government will act to ensure we do not land in the same situation

Implications for economies & citizens Growth will be relatively mediocre (3% - 4%) Unemployment will remain high Investment returns will be structurally lower Social benefits will be curtailed (already 14m people on aid)

Bottom line for affected households Expect limited growth in social benefits People will be increasingly forced to provide sufficiently for their own

retirement – but, SA retirement age low (55?) & falling? Likely structurally low investment returns will require a very high

level of savings

Source: Rian le Roux, Chief Economist - OMIGSA

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Economic Recovery

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Managing Risk

Identify Assess

Mitigate Control

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Identify & Assess

Analyse your investment risk at the holdings level Not just manager level Or Asset Level

Look for exposure to Foreign currency Dual-listed stocks Foreign sovereign debt by country Foreign corporate debt Equity

Quantify size of exposure and impact from volatility

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Mitigate & Control

Consider hedging out risk you don’t want exposure to currently

Use risk budgeting to limit your exposure to risky investments

Be clear on the risk tolerance of your membership and liability profile

Ask for frequent reporting

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THANK YOU