Sovereign debt risks become new threat to global financial stability

08:27, April 26, 2010      

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Although risks to global financial stability have eased as the economic recovery gains steam, advanced countries' sovereign debt risks could undermine stability gains and prolong the collapse of credit, world financial institutions have warned.

In the latest Global Financial Stability Report, which was issued on Tuesday, the International Monetary Fund (IMF) pointed out that the deterioration of fiscal balances and the rapid accumulation of public debt have altered the global risk profile.

In some cases, the longer-run solvency concerns could translate into short-term strains in funding markets as investors require higher yields to compensate for potential future risks, the report said. Such strains can intensify the short-term funding challenges facing advanced country banks and may have negative implications for a recovery of private credit.

On Friday, Greece formally requested the activation of a European Union (EU)-IMF support mechanism to pull the country out of its severe economic and debt crisis.

The Greek move came after a higher-than-expected 2009 budget deficit announced along with a lowered bank credit rating by the international rating agency Moody's.

Greece is not the only country that is suffering a sovereign credit crisis. Sovereign credit ratings of Iceland, Ireland, Mexico, Italy, Portugal and Spain have also been downgraded. Moreover, the sovereign credit of the United States, Britain, Germany and France has also been questioned.

Since the most severe financial crisis erupted in 2008, many countries have borrowed massive loans to stimulate their economy. The IMF estimated 4.5 trillion U.S. dollars of bonds would be issued globally in 2010, tripling the average amount of money that the developed economies have borrowed in the past five years.

In January, Moody's Investors Service warned that the United States' "triple-A" government bond rating could come under pressure in the very long term if the Medicare and Social Security programs are not reformed.

Sovereign risks have been transformed in a number of important ways. As the public sector stepped in to support financial institutions, distinctions between sovereign and private liabilities have been blurred and public exposure to private risks has increased.

Careful management of sovereign risks is essential for financial stability in the period ahead, the IMF said. To address sovereign risks, credible medium-term fiscal consolidation plans that command public support are needed.

In addition, authorities should endeavor to mitigate the transmission of sovereign risk through financial markets, for example by reducing the distortions from ratings triggers in statutory guidelines, and by strengthening collateral policies for OTC derivative exposures.

Even as these measures are implemented, risks will remain high in the short term and countries will remain susceptible to macroeconomic shocks and shifts in market sentiment.

"We have also noted that a number of sovereigns are under pressure," Youssef Boutros-Ghali, the chairman of the International Monetary and Financial Committee's Meeting, told reporters on Saturday.

"The membership urged the Fund (IMF) staff and management, and a number of large donor countries, to cooperate in assisting a number of sovereigns who are experiencing fiscal and debt difficulties," he said.



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