When ultimate refuge turns risky

Until the financial crisis of 2008, government bonds were the traditional haven for investors. More than a decade on, their nature has fundamentally changed. In any future crisis, sovereign debt will be a propagator of risk rather than a refuge.
Government debt has reached levels not seen outside of major wars. In advanced economies, it has risen to more than 100% of gross domestic product, from around 70% before 2007. The increase is the result of governments taking debt on to their balance sheets to finance bailouts of vulnerable financial institutions, and of deficit spending to prop up growth. Domestic government bond portfolios are large relative to banking system assets in Japan and several countries across Europe.
Despite record low interest rates and purchases by central banks, the risk of losses on these supposedly safe securities is increasing. Once purchased for risk-free returns, government bonds now offer return-free risk.
The danger isn’t increases in official interest rates, which are likely to remain low for a prolonged period, or inflation, which is still benign. The problem is the perceived creditworthiness of countries. The ability of a sovereign to print money to service debt doesn’t alter this dynamic. Investors may be unwilling to hold a nation’s debt when there is concern about financial solvency or currency stability.
The primary channel for risk is the complex linkage between the rapid buildup of government debt and its effect on holders. Domestic banks are obliged to hold these securities for prudential reasons, while local and foreign investors buy them as a safe asset or as collateral for borrowing or derivatives.
This is how the feedback mechanism works: Rises in sovereign yields and losses on existing holdings create selling pressure, driving prices lower. Higher rates for governments, which are the foundation of credit costs for all borrowers, then flow through into increased financing expenses for
consumers and businesses.
Losses on government bonds hurt the credit quality of holders. Over time, higher borrowing costs or tighter liquidity prompt increased defaults and nonperforming assets, undermining the health of the financial system. Selling by foreign investors puts additional pressure on bond prices and the currency.
As the availability of credit to banks and financial institutions shrinks and its cost increases, the beleaguered government is forced to support them to prevent financial distress, by recapitalising entities or guaranteeing deposits. Higher debt levels and government contingent liabilities exacerbate the crisis.
Meanwhile, slowing economic activity drives up fiscal deficits as tax collections fall and spending on “automatic stabilisers” such as unemployment benefits increases. The government’s financial position and flexibility deteriorate. At the same time, bank and investor weakness makes it increasingly difficult for the government to find buyers for its debt.
This process is reversible. Traditionally, after wars when government debt spiked, budget surpluses allowed rapid deleveraging. National debt-to-GDP ratios of the US, UK, Australia and Canada more than halved between 1945 and 1955.
Conditions today are fundamentally different, though. Increases in government debt to maintain economic activity are probable. Policymakers find themselves trapped and approaching the point of no return. It is ironic that actions taken to preserve the system and a key instrument — government bonds — now pose a key threat to financial stability.

—Bloomberg

Satyajit Das is a former banker, whom Bloomberg named one of the world’s 50 most influential financial figures in 2014