Borrowed time

With sovereign debt problems sweeping Europe, is an increase in insolvencies likely? Not necessarily, says Frank Tschentscher

May you live in interesting times” is reputed to be the English ­translation of an ancient Chinese curse heaped upon an enemy, and I cannot remember a time of greater uncertainty than the present one.

Skyrocketing government debt in Europe and elsewhere is threatening to derail the global recovery, and there are significant challenges for the year ahead.

Economists and market commentators suggest that the debt crisis can only be resolved by reducing or restructuring ­sovereign debt. They point to Greece, for example, and say it has a huge debt, no free-floating currency nor natural resources and generally does not have the ability to grow quickly for a sustained period of time.

Commentators say the UK has failed to put aside money in the boom years to offset its huge debt burden; that Ireland’s banking system is on its knees and that its ­commercial real estate is a ’black hole’ ­estimated at e20bn (£17.18bn) even before residential mortgages are factored in.

Then there are Portugal, Belgium, Spain and Italy, which, according to Goldman Sachs, in 2011 must raise e38bn, e85bn, e210bn and e374bn respectively to ­refinance their national debts.

However, there is something most ­commentators overlook when proposing a restructuring of sovereign debt – they forget to factor in what happens when a country defaults. Financial markets will make the defaulting country pay higher interest rates and the debtor will soon find itself paying not only the present value of loss, but also a premium for the uncertainty linked to it.

National governments have realised quickly how costly it would be if Ireland, for example, were forced to restructure its debts as part of a bailout. German and UK banks are Ireland’s biggest creditors, with e206bn and e224bn of exposure respectively, and would suffer greatly if forced to write off parts of their investments.

Furthermore, a debt restructuring would not only affect banks but also other corporates, such as insurance companies and investment funds, which bought government debt as a ’safe’ investment on behalf of investors. It is doubtful that governments will be quick to see those investments wiped off, as it would lead to a decrease in tax ­revenue together with taxpayer fury.

The real story is, therefore, the effect of the sovereign debt crisis on national tax policies, public spending on services or unemployment and other safety nets. ­Countries will need to begin fiscal ­consolidation as soon as 2011-12 by ­generating surpluses – and most governments’ answer to that is usually the ­introduction of tax hikes and spending cuts.

However, the Bank of England has already warned that more than one in two people with unsecured debts, such as ­credit cards or personal loans, are struggling to cope.

The UK Government is expecting 490,000 public sector jobs to be lost by 2014-15 as a result of its spending cuts. The cuts, wage freezes and job losses will also have a knock-on effect on the rest of the economy. Many private sector businesses rely on contracts with the public sector and the spending cuts will reduce their revenues.

Furthermore, the rise in unemployment is likely to have a negative multiplier effect. With people losing jobs, consumer spending will struggle to grow, leading to lower output and weaker demand. Finally, talk of job losses always has a negative impact on ­confidence, leading to lower spending and investment. Combined with other factors such as banks reluctant to lend, falling house prices and sluggish growth, the ­economic recovery may stall.

So does all this mean that the need for ­fiscal consolidation will trigger a new wave of restructurings in the private sector, as has been suggested by some?

Not necessarily, for reasons similar to those outlined above. There will no doubt be an increase in bankruptcies as people are unable to repay personal debts, but business restructurings are different animals.

Do not forget that this crisis originally started as a banking crisis. The financial sector is still recovering and there is simply no appetite to enforce claims against defaulting debtors and thus crystallise one’s losses. Staying invested appears more favourable than accepting unpleasant ­haircuts.

So, as far as the European banking sector is concerned, the band is still very much playing to the tune of ’amend and extend’, thus allowing banks to account for the full value of their investments. The downside is that by doing so they continue to create
so-called ’zombie companies’, which in an ideal world should not be allowed to continue.

However, we do not live in an ideal world and the chance that this is going to change in 2011 is slim.

Frank Tschentscher is a senior director at Schultze & Braun