22.01.2019 — BERENBERG/HWWI-Study "Sovereign Debt"

EXECUTIVE SUMMERY
In most countries, the global financial crisis led to a huge increase in
sovereign debt. Economic stimulus measures and bank bail-outs cost a lot
of money. Germany has succeeded in reducing its debt level in recent years,
but most other countries are still sitting on a mountain of debt.

Risk factor 1: Collapse of the economy and of growth. Thanks
to the strong performance of the global economy, the issue of debt has
slipped out of focus slightly in recent years. But this does not mean that the
problem has been solved. In principle, there are various factors that could
lead to a new debt crisis. But it would seem that the time for such a crisis is
not yet ripe. Because the economy as a whole is performing well, it is expected
to take some time before debt becomes a major topic for the financial
markets again.

Risk factor 2: Interest rate increases. The stricter monetary policy
goes hand in hand with a rise in capital market interest rates. This increases
governments’ cost of financing, and the burden of debt begins to weigh a
little more heavily. Nevertheless, there are structural factors at play which
indicate that interest rates will rise moderately and not dramatically, even in
the face of stricter monetary policy. In addition, the effect of higher interest
will be gradual, and thus subject to a time delay, because the majority of
debt is financed at low interest over longer periods. So increasing interest
does not constitute a direct risk at present.

Risk factor 3: Crisis of trust. Although the present low interest
rates may indicate that the high debt levels are unproblematic, a basic level
of caution is urged. The mood can change profoundly without much notice,
causing interest rates to skyrocket.

Risk factor 4: Contagion. The eurozone is less susceptible now than
during the euro crisis to the risk of a crisis in one member state spreading to
other countries. By contrast, emerging economies in particular are exposed
to significant risk of contagion. Yet the greatest risk stems from large countries
such as Japan and the US. If these countries were to lose the trust of
the financial markets, international ties mean that other countries would
very likely be caught up in the debt spiral.

Risk factor 5: Foreign debt. Emerging economies that hold a high
level of debt in foreign currency are subject to an additional exchange rate
risk. Time after time, increasing dollar exchange rates have prompted concerns
that emerging economies may be unable to repay their debts financed
in US dollars.

Risk factor 6: Demographics. The average age in many western
so cieties is increasing – with negative consequences for economic development
and for public finances. Nevertheless, this period of demographic
change is likely to be of short duration, with very limited potential for risk
in the medium term. It is considered very unlikely that demographics will
be a trigger for the next crisis.

Based on our assessment, we do not expect an extensive debt crisis
any time soon despite high debt levels, provided that the global economy
develops positively for the next year or two. However, we need to approach
the next downturn with caution. Italy could be the first country to
get into serious difficulties in the next recession unless the government
moves away from its economic policy plans in the meantime. In the me-
dium term, the US will also have to consolidate its state finances. This is
something the world’s largest national economy has succeeded in doing
several times before. Last but not least, in the long term Japan will need to
demonstrate how its mountain of debt can be overcome, as the central bank
cannot be the only solution.