Ask Not Whether Governments Will Default, but How

This is the first issue of Sovereign Subjects, a new Morgan Stanley publication focusing on sovereign risk in advanced economies. In this first installment, we take a broad perspective on government balance sheets and raise several themes to which we will return in more depth in subsequent issues. We encourage clients to provide us with feedback on this new publication.

Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by dvanced economies' governments. On the basis of current policies, most governments are deep in negative equity.

This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take.

So far during the Great Recession, sovereign (and bank) senior unsecured bond holders have been the only constituency fully protected from partaking in this loss.

It is overly optimistic to assume that this can continue forever. The conflict that opposes bond holders to other government stakeholders is more intense than ever, and their interests are no longer sufficiently well aligned with those of influential political constituencies.

There exists an alternative to outright default. 'Financial oppression' (imposing on creditors real rates of return that are either negative or artificially low) has been used repeatedly in history in similar circumstances.

Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection.

Read the rest here.

This is a very sobering article by a highly respected expert on sovereign debt in one of the world's most prominent financial institutions. I recommend reading it carefully and in its entirety.