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Sovereign risk rears ugly head in forex world
February 13, 2009 / 11:16 AM / 9 years ago

Sovereign risk rears ugly head in forex world

NEW YORK (Reuters) - The surge in credit risk among the world’s richest nations amid a crippling global banking crisis has spooked investors and fuelled a sell-off in their currencies.

Analysts say these countries’ looming struggles to repay hefty amounts of debt could haunt their currencies long after the financial turmoil subsides.

Since January, the risk of default by countries such as Britain and some in the euro zone, as measured by prices on their credit default swaps CDS.L, has expanded dramatically, prompting a sell-off in the pound and the euro.

“The relationship between CDS and FX could get even stronger as rates converge to zero, making it difficult for investors to differentiate between currencies from a monetary policy perspective,” said Michael Hart, European head of FX strategy at Citigroup in London.

“So people would focus more on fiscal concerns and the sustainability of their budgets.”

So far, the most worrying country has been Britain, once the bedrock of financial stability.

On Thursday, the cost of insuring UK borrowings spiked to a record high at 148 basis points on Thursday, or $148,000 (102,000 pounds) for every $10 million in debt over a five-year period, according to CMA Datavision.

The rise in CDS prices came after Moody’s said UK ratings are being tested by the strains facing the global economy even as Britain has introduced its stimulus package to combat the financial crisis.

But that rescue plan will widen the country’s budget deficit to more than 4 percent of gross domestic product in 2009 -- more than any G7 country apart from the United States -- analysts say.

Sterling has fallen as Britain’s CDS have surged, losing 2.8 percent so far in 2009.

“I do worry about defaults and that’s why I have reduced my sterling positions to zero,” said Axel Merk, portfolio manager of the Merk Hard Currency Fund in Palo Alto, California.

“There’s just no appetite for the pound,” he said. “It doesn’t help the British financial institutions that many of the deposits are sterling-based and the loans are in foreign currencies.”

U.S. DEBT BURDEN

The widely discussed U.S. debt burden of nearly $2 trillion this year arising from spending to combat the economic crisis has also rung alarm bells and caused the country’s CDS to surge.

CDS protecting U.S. debt soared to a near-record high at 84 basis points on Thursday, or $84,000 per $10 million debt as credit conditions in U.S. banks worsened. Investors were also concerned about the huge debt the United States needs to raise in bonds to stem the crisis.

But the increase in U.S. CDS prices saw a flight to the greenback, with the ICE Futures’ dollar index climbing 6.4 percent in 2009.

The dollar’s appreciation was consistent with safe-haven flows amid a rapid global slowdown, with investors brushing off the country’s extreme fiscal weakness. But that support is expected to fade as investors start to factor in the United States’ enormous debt load over the next several years.

Many believe, though, that a U.S. Treasury default is unlikely since all its debt is priced in its own currency and it could conceivably print more dollars to meet those obligations.

“There is still a long way between creditworthiness and default as the U.S. has the ability to raise taxes,” said David Gilmore, a partner at FX Analytics in Essex, Connecticut.

“Before we can raise the white flag on U.S. debt, we have to replace the dollar as a reserve currency, and that is not happening soon. The time to worry is when the bond markets are selling off because of fears about the dollar.”

Still, given the size of the stimulus and financial rescue package, analysts say the dollar’s stability could be at risk.

Creditors like China, the largest holder of U.S. Treasuries, would be looking at more than the credit rating or the risk of default. In the end, analysts say creditors would not want to see the dollar value of Treasuries devalued, which could happen if the United States prints its way out of debt.

Also vulnerable are Greece, Spain and Portugal -- all members of the 16-country euro zone -- especially after the Standard & Poor’s rating agency downgraded these countries this year.

Prices on their CDS have also jumped, with the cost of insuring $10,000,000 worth of Spain’s debt at $131,500, up 30.6 percent from end-2008, according to data from Bespoke Investment Group. That fuelled a sell-off in the euro, which has plunged more than 9 percent this year.

Still, no one in the market thinks the European Union will let any of these three countries default on their debt. If anything, the EU’s assistance to Hungary during the current crisis reinforced that view.

“But the severity of the crisis has crystallized actual default risk,” said CitiFX’s Hart.

Overall, many concede that defaults by the world’s heavyweights -- the United States, Britain and the euro zone -- may be slim at this point. But analysts agreed that, as the dust settles, investors would continue selling currencies with anaemic fiscal positions, such as the pound -- and eventually the dollar.

Editing by Jonathan Oatis

Our Standards:The Thomson Reuters Trust Principles.
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