China s Hidden Debt Risk

Debtor countries pay substantial risk premiums for financing their government debt.

And now the safety and security of US debt are at risk.

Investors were not worried about default risk on Spanish or Irish sovereign debt, or about Italy s chronically large sovereign debt.

With economic growth continuing, the potential risk posed by this debt will diminish.

Spain s huge risk premium has almost disappeared, but its debt problems have not.

Of course, some believe that the Fed s mass purchases of US debt poses an even bigger risk than Europe s sovereign debt crisis.

If heavily indebted countries have to pay heavy risk premiums, their debt becomes unsustainable.

Socializing public debt is already posing a risk to the still stable eurozone countries.

The risk stemming from local government debt is exacerbated further by massive amounts of non explicit debt acquired through arrears, credits, and guarantees.

A similar battle is now brewing about America s debt ceiling, which, if unresolved, introduces the risk of a technical default on US public debt.

Now China is experiencing a fourth instance of elevated debt risk, this time characterized by high levels of accumulated local government and corporate debt.

So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases.

Indeed, increased debt servicing obligations resulting from higher interest rates, along with weakening export prospects, ran the risk of reproducing an unsustainable debt burden.

Borrowing increases risk in any business you can t go bankrupt if you have no debt.

The risk premia on the sovereign debt of Greece, Ireland, and others have not diminished.

It didn t work. Eurozone sovereign debt turned out not to be homogenous with respect to risk.

Greece simply cannot afford to repay its debt at interest rates that reflect the inherent risk.

And, as Reinhart and Rogoff say, a correlation between high debt and low growth is a sign that one should investigate whether debt is a risk.

But the risk that the world s investors currently are trying to avoid by rushing into US, Japanese, and German sovereign debt is not a fundamental risk.

The risk of default or debt restructuring induces creditors to be more careful in their lending decisions.

Similarly, too big to fail banks would not care about the failure risk associated with debt financing.

But Europeans, while having launched national recovery plans, remain unwilling to take on a similar debt risk.

In some countries with high levels of debt and impaired growth, fiscal stimulus could raise the risk premium on sovereign debt and be counterproductive others have more flexibility.

Something started to cause investors to fear that Greek debt had a slightly higher risk of eventual default.

The major risk to the sustained role of the dollar is the large and growing US national debt.

debt service coverage reduces the financial risk to investors and translates into lower borrowing costs for the borrower.

But the promise of a return to the status quo ante of risk free public debt is not compatible with the continuing limits on the socialization of national debt.

To believe that any country issuing debt in its own currency is risk free as long as the exchange rate is flexible is astonishingly naive. For one thing, there is still inflation risk, particularly for countries with weak fiscal institutions and heavy debt burdens.

Another major risk of interest rate liberalization in China stems from rising public debt, particularly local government debt, which has grown significantly in the wake of the global financial crisis.

Investors thus assumed that they did not need to assess the credit risk of eurozone countries (national) public debt.

The key theoretical point in the transition to a debt fueled economy was the redefinition of uncertainty as risk.

But the growing risk associated with US Treasury bonds should prompt China to reduce its holdings of US debt.

NEW YORK Today s swollen fiscal deficits and public debt are fueling concerns about sovereign risk in many advanced economies.

The European debt crisis, however, remains, and markets do not fully trust the current calm. The risk premia that financially distressed countries must pay remain high and signal continuing risk.

What resulted was a wonderful system for diversifying individual bank risk, but only by magnifying the default risk of all banks that held what came to be called toxic debt.

Meanwhile, deficit and debt indicators have worsened, both in absolute terms and relative to emerging economies, and the average risk premium on advanced economies debt now exceeds that for emerging economies.

And the longer America s politicians take to resolve the debt ceiling issue, the greater the risk of an inadvertent accident.

Only the state is reliable enough to take on all debt, which private institutions are too risk intolerant to hold.

So why should we believe that the markets have been correctly pricing the risk of Greek, Irish, or Portuguese debt?

Debtor countries pay substantial risk premiums to finance their debt, which is reflected in their high economy wide borrowing costs.

There is also the risk of a disruptive decline in the dollar, which could prompt investors to flee US debt.

But as debts mount, and global interest rates rise, investors will become rightly nervous about the risk of debt restructuring.

The answer is simple the financial system s entire regulatory framework was built on the assumption that government debt is risk free.

But the more their politicians argue over the debt ceiling, the greater the risk that the wiring will become irreparably frayed.