Will country bonds lead to a new financial bubble?

More and more nations are becoming heavily indebted as their economies shrink in the face of a global economic crisis. To finance their deficits, these countries are issuing bonds at an alarming rate. Roberto Bissio asks how long this can go on.

LIKE the rest of the world, Wall Street operators took a break to watch on their computer screens or on their mobile phones the historic moment when Barack H Obama was sworn in as President of the United States.

The new leader, young, intelligent, popular, promised 'action, bold and swift, and we will act - not only to create new jobs, but to lay a new foundation for growth.'

However, as soon as he finished his speech, Wall Street continued its downward trend and the Dow Jones Index closed the day below the symbolic 8,000-point barrier, with a 4% loss, the biggest drop ever recorded on a presidential inauguration day, generally marked by optimism.

The accumulated loss in shareholders' value over the past eight months has reached 40%. At least one out of three families in the United States has its savings or its pension plans placed on the stock exchange or in funds with returns linked to the stock exchange. 'Homes have been lost; jobs shed; businesses shuttered,' said Obama in his inaugural speech.

According to analysts, the weakness of major banks was the immediate cause of Wall Street's inauguration day drop, which spread to Europe and Asia the following day. In the United States, both Citigroup and the Bank of America are alive only because the government will not let them fall and, although nobody wants to say the word 'nationalisation', this would seem to be inevitable.

In the United Kingdom, the Royal Bank of Scotland is doomed to a similar fate. Prime Minister Gordon Brown's announcement about a new rescue plan for London finances was perceived by public opinion as a tacit admission of the failure of the previous plan, launched a few weeks ago.

Country deficits are skyrocketing, as a result of the cost of bank rescues, generous spending to stimulate the economy, less income because of tax cuts and less fiscal revenue generated by shrinking economies in recession.

The governments of the richest countries are becoming indebted  at a hitherto unprecedented speed and magnitude.

Javier Santiso, director of the Organisation for Economic  Cooperation and Development (OECD)'s Development Centre, estimates the total additional debt of the richest countries in the world between January and September 2009 at $3 trillion.

The various mints cannot print bonds fast enough. The problem is whether they will find buyers.

At the present time, those who withdrew their money from high-risk shares and investment funds are purchasing bonds as a temporary way of placing their capital 'under the mattress', safe but with low interest.

But the major purchasers of government bonds are not insurance companies or pension funds, but mainly 'surplus' countries, in particular China and the Gulf oil monarchies. However, petrodollars have dried up with the drop in the price of crude oil and it is possible that China will not increase its reserves in 2009, as a result of the decline in its exports and the need to finance its own stimulation plan.

On 7 January, the Deutsche Finanzagentur GmbH (German Financial Agency) managed to place only 87% of an issuance of 3 billion euros and the Bundesbank (German Central Bank) had to purchase the remainder, hoping to resell it later.

Germany, considered to have the most solid and stable economy in Europe, pays out 3.1% interest on its bonds. Italy pays 4.3% and Greece 5.2%. An increase in the interest rates is needed to make attractive the bonds of countries considered to be less stable, a phenomenon known in Latin America as 'country risk'.

Credit rating agencies have already started lowering the grade of some countries, such as Spain and Greece, and it is to be expected that this results in higher interest rates on their bonds. Other countries, such as Russia, are 'liquefying' their debts by simply printing more banknotes, with the corresponding devaluation of the rouble as a result.

Developing countries with fiscal deficits that usually resort to issuing bonds to finance their debts must now compete with bigger countries as bond sellers, and will only be able to do so by paying out a higher interest rate, thus entering into the vicious circle of an external debt that becomes unsustainable. Pakistan, the Philippines, the Balkans and even part of Eastern Europe may quickly find themselves in such a situation, affirms Santiso.

If the crisis continues into the second half of 2009, even countries with a surplus and with important reserves, such as China, Brazil and India, may quickly find themselves losing them. Russia lost 25% of its reserves between August and November 2008 in an attempt to prevent the rouble from devaluating and Brazil spent up to $1 billion a day last September to defend the real from a speculative attack.

'If, after two or more years of monstrous fiscal deficits,' writes analyst Martin Wolf of the Financial Times, 'the US is still mired in unemployment and slow growth, people will ask why the country is exporting so much of its demand to sustain jobs abroad. They will want their demand back. The last time this sort of thing happened - in the 1930s - the outcome was a devastating round of beggar-my-neighbour devaluations, plus protectionism.' This would resuscitate the 'demons of our past', in particular economic nationalism.

A renegotiation of the world order is on the agenda, but it is no longer enough to reach an agreement among the Group of Seven major industrial countries or the Group of Eight (the seven plus Russia), because they will all be undergoing the same difficulties.

'For the world has changed, and we must change with it,' announced President Obama in his inaugural speech.

We can only hope that the politicians able to make this change a reality receive his words with more attention and less disdain than that shown by the markets.

Roberto Bissio is Executive Director of the Third World Institute (IteM) in Montevideo and Coordinator of the Secretariat of Social Watch. This article is reproduced from the South-North Development Monitor (SUNS, No. 6628, 29 January 2009), which is published by Third World Network.

*Third World Resurgence No. 221/222, January-February 2009, pp 5-6