Title: More sovereign debt headaches

Sub-title: First it was Greece, then Ireland. Now Portugal and even Spain are in financial trouble. What does this mean for Canadians?

 

In hockey, there is an old saying that when a losing team’s general manager says publicly that he backs its coach 100%, that means they coach’s days are numbered, and he had better start looking for a new job.

 

That old truism now seems to apply to countries. Last year, just days before Greece and Ireland applied for financial bailout assistance from the European Union and the International Monetary Fund, the prime ministers of both countries made loud statements that no such help would be needed.

 

Last week, it was José Socrates, Portugal’s prime minister’s turn to say publically that the country could sidestep a bailout. Whether that is true remains to be seen. But what is certain is that the increasing number of countries that are slipping into insolvency raises questions about how safe government bonds are. In recent days, speculation has increased about whether Spain too, Europe’s fourth largest economy could be at risk.

 

Are government bonds really safe?

This heightened uncertainty about sovereign debt comes at a strange time for Canadians. During the past decade investors have witnessed an Internet bubble crash and both real estate and general stock market plunges and bounce backs. As a result of the volatility, Canadians (a conservative lot to begin with) have been increasingly relying on advice their dads gave them: that the safest place to invest is bonds and more particularly government bonds.

 

Now it looks like that advice may no longer be totally true. That’s because while the Canadian government may be in relatively good shape, many foreign governments have dug themselves into big financial holes. Even the United States federal government, where nervous investors often go to seek a safe haven, has been warned by both Moody’s and Standard and Poor’s about its distressing financial position and many of its state and local governments may be forced to restructure their debts.

 

This is all real bad news for Canadians, particularly investors looking for foreign diversification in their portfolios and recent immigrants who like to hold assets, such as bonds, in their countries of origin. If government bonds are no longer safe, that also raises the question of where can investors go?

 

Other risks: inflation and contagion

However experts say that the bigger risks stemming from sovereign debt defaults are systemic. “It’s a bit like when Lehman Brothers went bankrupt a few years ago, the fact that they could not pay their  bills put the financial security of  those they owned money to in doubt as well,” says said Paul-André Pinsonnault, a senior fixed income economist at National Bank Financial. “The same thing could happen at a national level. If one country defaults, it could have a domino effect and freeze up a large part of the European financial system.”

 

While the effect on Canadian bondholders would be contained, says Pinsonnault, there would be economic consequences. “Europe is an attractive export market for Canadian companies, and if demand there slows, it could hurt production and thus jobs here.

 

The other threat, this one stemming from the United States, where the central bank recently launched a second round of quantitative easing, is that the country could try to dig its way out of its debt hole by printing money to pay off its lenders. This carries the risk of spreading inflationary pressures into the system, though Federal Reserve governor Ben Bernanke has indicated that he would not let those pressures get out of hand.

 

The short term should be fine

The good news according that in the immediate short term things are seem to be holding up. “Portugal had to go to the markets to raise money today (Wednesday) and they raised all that they needed,” says Pinsonnault. “However over the longer term, Portugal’s economic outlook carries its fair share of uncertainty.”

 

Pinsonnault isn’t kidding. According to a recent poll by Reuters, 44 out of 51 economists surveyed believe that the country will need economic assistance sooner or later. If that happens, investors will looking to see where the next shoe will drop.

 

One clue: it will probably be the country whose leader says that its financial position is just fine, and that it will not need a bailout.

 

Peter@peterdiekmeyer.com

 

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