Sovereign default risk, fact or fiction?

May 14, 2010

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

If a gauge is needed to measure how concerned investors are at about sovereign default risk, we need look no further than the price of gold which has made fresh all time highs this week.

Assets with intrinsic value are in demand.

U.S. Treasury debt has also fared well on the back of safe haven buying over recent weeks; it is possible that the dollar could be entering into a renewed period of broad based strength as a consequence of risk aversion.

However, the solid demand for U.S. debt has not prevented the US authorities being wary about the risk of contagion from the European fiscal crisis;  after all the US budget deficit may hit 11 percent of GDP this year which is not too far behind that of Greece (at 13.6 percent).

President of the Federal Reserve Bank of St Louise James Bullard warned this month that Greece’s sovereign debt crisis was spreading and posing risks to the US economic outlook.

Clearly the Greek crisis has shaken both investors and governments across the board.

The EU’s huge EUR750 bln support package was designed to overwhelm the risk of default within the EMU.

That said there is still the possibility that Greece could be driven to debt restructuring of some kind eventually.  EUR440 bln of the EU’s package will have to be drawn from the Eurozone’s sovereign states and in Germany there appears to be significant popular resistance to the notion of huge fiscal transfers.

If Germany refuses to continue bank rolling the EMU support fund and if Greece cannot stomach the internal devaluation that would bring its competitiveness in line with Germany’s then default in the Eurozone’s periphery may yet happen.

In general, however, risk of sovereign default remains low, but it is higher than it has been for some years.

Bank of England Governor Mervyn King remarked this month that the financial crisis is still only halfway through.  The huge fiscal deficits presently carried by many governments were created as a consequence of the financial crisis.

The next phase will be the repair of sovereigns’ financial positions.  The Greek economic crisis has driven home the costs of delaying fiscal prudence and has injected a new urgency into the need for budget reform.

Looking ahead, the reigning in of government budgets will weigh on economic growth potential and worsen the trading environment for the corporate sector.

The rest of the year may thus be characterised by a continuation of the paring back of risky positions in the market which will support the US dollar and could make the going tough for assets such as equities and oil.

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