The Four Stages Of A Sovereign Debt Crisis

Bryan Rich
updated | Author's Website

It’s easy to lose perspective on where the global economy stands … to be confused by the daily deluge of information.

So today, in the first of a two-part series, I want to give you some perspective on the big-picture and where we are today, because as an investor the “big-picture” is critical for you. It can mean the difference between making and losing a lot of money.

So let’s take a look …

First, we endured the sharpest fall in global economic activity since the Great Depression and one of the most threatening financial crises. Does that mean we should expect a quick return to normalcy? It’s not likely.

And here’s why …

The IMF has done what is perhaps one of the most thorough studies on recessions that share the combination of a global recession and financial crisis – like the one we’ve recently experienced. And its study shows that the recoveries of past recessions with these dualities tend to be longer and slower than normal recoveries – typically around five years until economies sustainably resume trend growth.

That means, if you mark the start of the recent crisis as late 2007, we’re less than three years in! Therefore, you should expect more bumps in the road ahead.

History also shows us that financial crises are generally followed by sovereign debt crises, which is where we are now.

And Sovereign Debt Crises Tend to Play Out in Four Stages …

Stage #1: Burgeoning Deficits

In a financial crisis government spending increases dramatically in attempts to stabilize the financial system and stimulate economic activity. Tax revenues fall. Fiscal surpluses turn into deficits … and economies with existing deficits keep piling it on.

How it’s playing out …

All of the  Emu's members are guilty of runaway spending.
All of the Emu’s members are guilty of runaway spending.

All sixteen members of the European monetary union have violated treaty limits on allowable budget deficits – some to the tune of more than four times as much! Moreover, the leading economies of the world have all seen their deficits shoot higher, some to record levels.

In fact, the deficit spending that’s gone on in recent years can be summed up as follows: Over 40 percent of world GDP comes from countries that are running deficits in excess of 10 percent.

Stage #2: Ballooning Debt

When economies are contracting or even growing slowly, bringing these deficits back down to earth becomes an unenviable challenge. Governments have to make ends meet by turning to the markets. Then those burgeoned deficits turn into growing debt loads.

How it’s playing out …

When debt reaches 80 percent of GDP threshold, the borrowing costs for governments starts ticking higher and so does the market scrutiny. The IMF says five of the top seven developed countries in the world will have debt levels exceeding 100 percent of GDP in the next four years.

Ratings  agencies have become increasingly pessimistic on Greece, Spain and  Portugal.
Ratings agencies have become increasingly pessimistic on Greece, Spain and Portugal.

Stage #3: Downgrades

When deficits and debts rise and economic activity appears unlikely to curtail fiscal problems, the credit worthiness of the government falls under intense scrutiny. And that’s when we see downgrades.

How it’s playing out …

Greece’s sovereign debt rating has been downgraded to junk status. Spain has lost its AAA rating and the UK could lose its AAA status if its deficit isn’t addressed. Japan’s outlook has been cut to negative and rating agencies have even warned the U.S.

Stage #4: Defaults

Higher  borrowing costs can push troubled countries into default.
Higher borrowing costs can push troubled countries into default.

This is the final and most deadly stage. That’s because downgrades only make the vicious cycle of weak economic activity and growing dependence on debt worse.

When investors see more risk, they require more return. Therefore, the borrowing costs for these troubled countries rise. Then it becomes harder to finance spending needs and harder to finance existing debt. And that’s when we see defaults.

How it’s playing out …

When S&P downgraded Greece to junk status, it warned debt holders should be prepared to receive just 30 cents on the dollar.

What’s more, even with a $1 trillion rescue package committed by the EU and IMF, the long-term solvency of Greece looks bleak. And not just for Greece. But Spain, an economy that represents 12 percent of GDP for the euro zone is shaking as I write this column – rumored to be next in line for a massive funding request.

In sum, a sovereign debt crisis has arrived. The fuel for contagion: Fear.

And unless governments can demonstrate they’re willing to take tough steps to reign in debt, crisis can spread quickly.

As I said, history shows us that financial crises tend to be followed by sovereign debt crises. History also shows us that sovereign debt crises tend to lead to currency crises – an area I’ll explore next week. Stay tuned.

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