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Saturday, March 15, 2008

Investing: Euro-denominated sovereign debt

What with the U.S. Federal Reserve jumping in to keep investment bank Bear Stearns afloat, gold and oil hitting consecutive all time highs, and the U.S. dollar continuing to depreciate with banana republic speed, many investors are shifting their minds from greed to fear and contemplating the best strategy to ride out what may be a difficult and unpredictable era ahead. In a financial crisis, regardless of its nature (a big bear market, credit crunch, currency instability, inflation or deflation) the usual outcome is that everybody loses—the wealth-creating and -preserving mechanisms of the marketplace and economy are disrupted, and this causes assets of all kinds to depreciate.

In such an environment, the prudent investor shouldn't think about how to make the most of the calamity, but rather how to lose the least; when everybody loses, those who lose the least emerge in the best relative position, and those who preserve their assets when those of others evaporate are able to take advantage of the once in a generation bargains which emerge when Time magazine trumpets the end of civilisation and there are twenty sellers for every buyer in every market.

I am not predicting that the present situation will escalate into a full-fledged 1929–1932 deflationary credit collapse—while I think it is possible, at the present I'd put the probability of such a dire outcome at between 10 and 20 percent. But still, the possibility exists, and one should consider it among other scenarios when making investment plans.

In the days of the gold standard, gold itself was the ultimate store of value. Currencies may come and go, be revalued and devalued, but an ounce of gold could always be converted into whatever currency you needed to buy something, and the same ounce of gold which would have bought you a fine suit of clothes in imperial Rome will still do so today. In the age of paper money, unbacked by gold or any other physical store of value, there is no such universal refuge. Certainly gold remains an asset with inherent value which doesn't depend upon the integrity or solvency of any issuer, but its value in terms of currencies is a matter of supply and demand and the psychological dynamics of markets, and has historically exhibited a volatility with respect to purchasing power which makes it less of the sure thing it was in days of yore.

Consequently, in this age of floating, unbacked, paper currencies, the conventional refuge in times of financial turbulence has been short-term “sovereign debt”: interest-bearing obligations (bonds, notes, bills) issued by the central banks of sovereign nation states who issue the currency in which the instruments are denominated. The argument for the safety of such assets is as follows. First, since they're short-term (say 90 days to 2 years to maturity), your principal is not at risk due to a spike in interest rates—you can always simply wait until the bond matures and is repaid at full face value. Second, since they are obligations of the same government which issues the currency in which they are to be repaid, in extremis said government could simply print the money needed to repay its debtors. Now, to be sure, in a hyper-inflationary environment that currency may have depreciated compared to that with which you purchased the bond, but the short term means that except for the most dire circumstances (which are unlikely to ensue without ample prior warning to those who know how to read the signs) the depreciation will not result in a catastrophic loss of principal.

Not long ago, an investor could structure a defensive “hunker in the bunker” portfolio composed of short-term treasury obligations of the major industrial nations (Japan, Germany, Britain, France, the United States, Italy, Canada, the Netherlands, Australia, Sweden, Switzerland, etc.) each in their own currency, and balance currency and geographical risk around the globe. The advent of the Euro has complicated the situation. Euro-denominated debt is issued by governments in the Eurozone. While, say, the United States or the United Kingdom can always crank up the printing press to pay off their maturing sovereign debt, countries which have adopted the Euro are beholden to the European Central Bank and cannot create new Euros solely by a decision made at the national level. Now consider the case where, for example, a severe economic downturn has caused unemployment to rise in one of the weaker members of the Eurozone to double-digit figures, and social and political agitation threatens to destabilise the government. Mightn't those in power, like the British government which, when faced with the consequences of remaining within the constraints of the European Exchange Rate Mechanism (ERM), was forced to bail out in September 1992, be forced out of the Euro and, by exercise of their sovereign power, declare their Euro debts to be repaid at a discount (or with an extended maturity, which is equivalent) in their own new national currency?

To date, the Euro has never faced the kind of turbulence which brought down the ERM. History has not been kind to monetary unions unreinforced by a political union able to prescribe the fiscal policies of its members—it is an untested currency and store of value. One has to ask, therefore, whether Euro-denominated treasury obligations issued by member states should be deemed equivalent to those issued by governments with complete control over their own currencies, such as those of the United States, Japan, and the United Kingdom. I think the quick answer is no, but I wouldn't worry much about French and German government bonds: the Paris-Berlin axis cannot and will not tolerate instability or uncertainty regarding the Euro. It's the peripheral states you have to worry about. I wouldn't obsess about this, but I'd also pause before considering all sovereign debt issued by Eurozone governments as equal, or assuming that the monetary nationalism risk was totally priced into the interest rate.

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Posted at March 15, 2008 21:09