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Which domino will fall next?

Sep 19, 2011

Its deja vu time once again. If in September 2008, Lehman Brothers was looking down the barrel of a gun, in September 2011 its Greece. If Greece meet its austerity targets and eventually go bust, nations like Italy and Spain might very well be next. How does one tell that a Greek default is eminent? Well, the yields on 2-year government bonds in Greece are driving this point home. At present, the Greek 2-year bond is signaling that default is imminent. Yields on these bonds are currently at a whopping 55.7%. Just last week, they almost hit 80%. These levels are absolutely unsustainable. Investors seem to have lost faith in the economy. Yields at these levels make the value of Greek bonds effectively worthless. Stock markets world over are also feeling the heat on account of Euro contagion fears. Will the country run out of cash, and run itself aground?

For some background, the PIIGS (Portugal, Ireland, Italy, Greece and Spain) countries were able to take the benefit of their Euro status and borrow at low interest rates in a uniform currency. They loaded their balance sheets with debt, which they couldn't eventually repay post the 2007-08 slowdown. Greece especially, whose major industries are shipping and tourism was badly affected during the crisis. One of the biggest concerns investors have with regards to the PIIGS is whether their governments will be able to maintain fiscal discipline and repay their creditors. Or would they default and need to be bailed out?

With this in mind, we decided to see which other countries have a large amount of foreign debt outstanding. This will help us see how much of a particular country's assets are held by foreign nationals. If a country's liabilities are mainly held by outsiders, the chances of a debt default are much higher, than if they are held within the country itself. In India for example, a large portion of the government debt is held domestically either by Indian corporates or individuals. This makes India relatively more secure from a debt default perspective.

Source: McKinsey Global Institute
Note: Figures represent net position in 2010, numbers in US$ trillion


Not surprisingly, the US is the largest foreign debtor, with its foreign liabilities exceeding its foreign assets by over US$ 3 trillion, or around 21% of its GDP. This is on account of the country's low savings rate and its perpetual current account deficit, which needs to be met by foreign borrowings. Spain, Italy and Greece all feature in this list of the world top ten debtors.

Source: McKinsey Global Institute
Note: Figures represent net position in 2010, numbers in US$ trillion


To fund borrowings one needs creditors. Japan is the world's largest creditor. This seems surprising, since Japan has a debt/GDP of over 200%. However, most of its debt is held domestically and not by foreign nations. Japan and China both hold large amounts of US treasuries. Germany is also a major creditor having lent a lot of money to the weaker European nations. Asian and Middle East economies have also been diversifying their portfolios worldwide over the past few years.

Either way, by the looks of it the US and the Euro Zone nations are pretty much in the danger zone. Fiscal prudence is very important, which these nations seem to have ignored. Plus, increasing the savings and investment rates domestically is far more sustainable than borrowing from overseas. One can domestically adjust interest rates as well as money supply and avoid a default. However, if one borrows from outsiders, then aspects like exchange rates, timely repayments and maintaining fiscal discipline are paramount.

From this we can even learn a lesson about the kind of stocks one should consider investing in. One needs to look for companies like Apple, Infosys, and Nestle etc which take on very little external debt but rather are able to fund their operations through internal accruals. These companies are able to weather any storm and hold their heads up high especially in times of adversity.

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