Where are we in the Sovereign Debt Issue?

I am sure the predominant question that everybody would like to ask is the title of the post. So I thought it would be a nice time to take stock of the situation (NOTE: take stock is more of a metaphor). As usual i would like to give you some important statistics and ask a few important questions and then would prefer to leave it to the best senses of the read to come up with rational answers. The last part of the post will consist of some important scenarios that investors have to consider in the present economic environment.

Is the Sovereign Debt crisis winding down or at least are we seeing light at the end of the tunnel? One would only wish and hope that we could give straight short postive answers to the question. Unfortunately the only short answer is that we still have a long way to go. The reason for this negative brutally frank answer is clear. Despite all the rhetoric about the Greek package, Greece is only a small fringe player in Europe. That may surprise the passive observers of the economy. But anybody who follows the bond market will understand that the problems for Greece are only partly over and the problems for ther other countries, especially Spain and Italy are just starting.

The bond markets are likely to panic far more than the present (unless we have dramatic action by the world's central banks) in late June and early July because a number of countries have to roll over or repayment of substantial amounts of outstanding debt.

In the next five months the amount of debt that various countries in EU have to roll over varies from about 4% in the case of Ireland to about 9.7% in the case of Italy. EU as a whole needs to rollover or repay about 6.2% of its total outstand public debt.

The following statistics will probably place the issue in a better perspective (the total quantum of debt is given in brackets).

Italy needs to roll over 9.7% of total debt (which stands at US$1.4 trillion)

Portgual needs to roll over 8% of total debt (which stands at US$286 billion)

Spain needs to roll over 4.7% of total debt (which stands at US$1.1 trillion)

Ireland needs to roll over 4% of total debt (which stands at US$867 billion)

Greece needs to roll over about 6.2% of total debt (which stands at US430 billion)

UK needs to roll over about 4.4% of total debt (which stands at more than 848 billion Pounds)

The total outstanding debt is likely to be more than that cited above as most of the statisitcs are for total debt at the end of February-March 2010 while in the case of UK the outstanding debt is as on 18 February 2010.

Therefore the options that the Central bankers, especially ECB, have are rather limited. They (ECB) can either rollover the debt by printing more money and using the procceds to buy bonds or simply allow a default. The second option is inconceivable, especially on such a scale. So they will have to buy bonds and concurrently allow the banks to pledge any collateral, even if it has 100% likelihood of default being pledged with the ECB. Among the other smaller measures that the ECB will invariably take up will include a cut in interest rates (all the way to Zero - and they can still cut 1%: not bad) and providing the banks with unending supply of loans on very easy terms. This money will (after about 6-12 months) come back into the markets. But in the process the ECB would have only postponed the issue by that much time and would help create the mother of all bubble which will probably burst in about 18 months time - IF EU is able to weather the present perfect storm.

There are a number of scenarios that an investor would have to seriously consider. These are enumerated below. Though some of them are unthinkable at the present juncture, the more prudent investors should probably have an open mind about various options.

1. What would be the market reaction if the ECB were to announce Quantitative Easing by buying their own bonds (most of which are anyway near junk)?

2. What would the government do with their largely insolvent banking system? Till date sovereign debt was considered a risk free asset and its holdings went into the calculation of the banks capital adequacy ratio. Imagine if this were to happen in India: most of our public sector including LIC would be insolvent as they hold GSec's.

3. How to deal with the hitherto unthinkable: How would the market react to a collapse in the Euro (as it exists in its present form)?

Probably the Governments will ask their banks (or even better Goldman Sachs) to rig up the markets by buying all the indices and would ask JP Morgan and HSBC to keep selling gold futures so that people dont panic.

Deja Vu all over again.