Sovereign risk - decoupling is dead

October 24, 2008

Credit spreads have eased a tad, suggesting the interbank lending market may be in recovery. Sovereign risk however has now come to the fore with Iceland going kaput, Hungary teetering and yesterday ... Argentina.

For Iceland, foreign debt is the problem. The banks owe three times GDP. Late in 2001, Argentina reneged on its $US95 billion foreign debt. It was the biggest default in history. Now Argentina's funding needs have doubled in the past year to $US14 billion and its long bonds (2033) are fetching just 22c in the dollar, a yield of 30% for anyone with a very hairy chest.

The Government has just stepped in to rescue $US30 billion in pension funds. The South American republic has a long and tortured history of corruption and financial mismanagement but its predicament still bodes poorly for the rest of the developing world in the present crisis, and more critically for food supplies as this is a very large wheat exporter. Inflation is pushing 20%.

Australia, of course, is in an entirely different league but it should not be ignored that, as a big current account deficit country, we face similar challenges on a smaller scale.

With the latest inflation figures rocketing to 5% - as the imperatives of growth supersede the need to attack inflation. Still, the RBA will be painfully aware that as it continues to slice rates it imperils the $A.

Having swapped $50 billion-odd in liquid assets into the banks in exchange for their securitised mortgages, the whole system is underwater on the $A as the banks have relied on billions in wholesale foreign funding to finance our mortgages.

A haircut has been taken on the $A and someone is paying for it. Should rates go down further that will only increase the pressure on the $A - already under pressure from plunging commodity prices - as foreign money goes elsewhere.

We have become dangerously dependent on foreign money and now our currency is captive, as is the RBA in its medium-term monetary stance.