Wednesday, December 9, 2009

Sovereign Default Risk Puts Floor Under US Dollar

Note to readers: The following post originally appeared at Examiner.com. I have recently taken a position as their Canadian Economy writer. I will still be contributing to Futronomics, but some of the articles will be cross-posted. You will notice a difference in the style of writing in such articles, but I pledge to stay true to the spirit of my work to date. Naturally, the work will be a little more "Canada centric," but most will still have relevance for my American readers. Feel free to visit my Examiner page often and subscribe to my posts if you wish. I am paid minimally based on article views, subscribers and comments. However, this is more of a resume boosting endeavor, so we will see how it goes...

When Dubai World, the state backed infrastructure company, warned of its inability to meet obligations without assistance two weeks ago, some analysts noted that it had the potential to spark fears of other susceptible nations to do the same.

This week, markets have been tentative after rating agencies confirmed those fears with downgrades in Europe.

Greece, widely known to be the weakest among major EU economies, was the first to be given a downgrade by Fitch. Its rating was slashed to BBB+ and reiterated that further cuts may be in the offing. Standard and Poor's also expressed heightened caution a day earlier, stating that they have a "negative" outlook on the future direction of ratings. Ratings were also lowered on Greek commercial bank debt.

Ratings downgrades are considered significant events because certain investment institutions (such as pension funds) are only allowed to invest in debt that is considered investment grade. A downgrade could force selling of government bonds, pushing interest rates up and exacerbating the problems.

Fitch noted that the historical record of fiscal management in Greece had been poor and that they are, "not convinced that the substantive pension reform and other measures necessary to contain public spending pressures and broaden the tax base will be sufficiently strong to materially reduce debt."

Credit default swap contracts (the cost to insure against default) on Greek sovereign debt has risen substantially over the past two days to 232 basis points.

Spanish sovereign debt risk also rose, as Standard and Poor's put the nation on "watch negative."

Fears of greater contagion have put higher risk premiums on almost every European nation. As a result, the euro has fallen by 3% against the US dollar in the last week. Over the past few years, the US dollar has strengthened when risk aversion increases. The reaction could prove detrimental to other currencies like the Canadian and Australian dollars, which have also benefited from risk seeking investors borrowing money in the US and taking it abroad.

Willem Buiter, professor at the London School of Economics, and incoming economist with Citigroup, suggested that a bailout by the European Union may be a last-resort option at some point for Greece. But certain German officials have warned against this, asserting that it could set precedents for other EU members such as Ireland, Italy, Spain, and Portugal to expect the same.

Watch a Bloomberg interview with Buiter below. Interested parties can follow daily CDS movements here.



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