2010-03-01

Andy Xie on Greece and the coming sovereign debt crises

Greece's Long, Slippery Slope to Default
Without painful cutbacks, governments are heading toward bankruptcy. As long as they can borrow, inflation won't be too high. And when governments can't borrow any more from financial markets, they can print money. Countries such as Japan and the United States can do this. But printing money is a way to inflate away debts, and it's technically a form of bankruptcy.

Hence, the sovereign debt crisis is ultimately an inflation crisis. What occurred in Germany in the 1920s could be repeated in Japan and the United States in the future, possibly within a decade.

Small economies that borrow in foreign currencies are facing stress now because the market knows they have less wiggle room. Their financial situation isn't black and white; there is a vast gray area between solvency and bankruptcy.

The crisis in Dubai, for example, stirred up a financial storm a couple of months ago. Abu Dhabi was supposed to bail it out. But did Abu Dhabi really bail out Dubai? It's not clear. An announced US$ 10 billion in assistance turned out to be only US$ 5 billion. The other half was tied to a previous loan. Besides, US$ 10 billion won't be enough to rescue Dubai from US$ 100 billion in debt.

The market was interpreting the assistance as a first step toward a complete bailout. Instead, now we are hearing that Dubai is asking creditors to take a 40 percent haircut. Is that default? The euphemism is debt restructuring. But to the banks, it feels very much like default.

Dubai's story provides a good example of what could happen in the future in other countries. When financial markets panic, vague bailout talk appears. The language is never clear. But it does soothe the market and can force hedge funds to cover short positions, which pushes up the value of distressed bonds. Nothing changes psychology like rising prices. Even without any change, the crisis feeling dissipates. And once bitten, hedge funds hesitate to come back. Such stalling strategy is a cheap way for governments to push back the inevitable. Ultimately, default is inevitable, even if it is done quietly.
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