Déjà vu Sovereign Debt Crisis

1. Déjà vuSovereign Debt Crisis OMAC Breakfast 3rd Quarter 2010

2. The only man who sticks closer to you in adversity than a friend is a creditor.  Author Unknown

3. Sovereign Debt External Foreign Countries Foreign Banks Foreign Companies Foreign Currency Bonds Government borrows money externally and internally using bonds Internal Local Companies Local Investors Local Currency Bonds

4. Creditors • Other Countries • Foreign Currency Bonds • Euro-bond • Companies • Treasuries • Pension Funds • Bonds, Index-Linked Gilts • Individuals • Fixed Interest investments, Retail RSA Bonds

5. Credit Risk Not being able to pay your debts • Company • Declared bankrupt • Legal framework protects creditors • Debt has determined seniority • Country • Can’t be declared bankrupt • Sovereign – no legal framework holds • Debt restructuring program with IMF involvement

6. Sovereign Debt Public Debt as a Percentage of GDP (2007) Source: CIA World Book

7. Sovereign Debt • Ranking of countries by comparing sovereign debt to country GDP • South Africa ranks 87th with a debt at 29.5% of GDP • 60% or less considered prudent Public Debt as a Percentage of GDP (2009/10) Source: CIA World Book

8. Boom to Bust • Countries borrow in order to finance further growth • Capital projects like infrastructure • Lending happens in booms • 8 lending booms since 1820s • Most recent was in 1990s to Latin America, emerging Asia and former Communist countries • Credits include USA, Japan and Western Europe • Driven by political change or new investment opportunities

9. Boom to Bust • All lending booms so far have ended in some countries going bust • Busts can be triggered by • Deterioration of the terms of trade of debtor countries • Recession in the core countries that lent capital • Rise in international borrowing costs • Crisis in a major debtor country that spreads globally • Change in government or regime

10. Boom to Bust Examples The 1920s lending boom turned to bust after in the 1930s after the collapse of commodity prices and a recession in the USA led to sovereign debt defaults Over-lending in the 1970s went bust after high interest rates in the USA combined with a recession in 1980 to 1984

11. Sovereign Defaults In the last 35 years, how many countries do you know that have either defaulted on or significantly restructured their sovereign debt?

12. Sovereign Default Nigeria Madagascar Liberia Turkey Russia Ukraine Grenada Cote d’Ivoire Mexico Angola 48 Honduras Serbia Tanzania Cameroon Poland Cuba Egypt Paraguay Uruguay Brazil Uganda Romania Argentina Bolivia Ecuador Chile Mozambique Morocco Malawi

13. Sovereign Default IMPACTS • Reputational Costs • Greater spreads on international debt • More expensive to raise debt in foreign markets • International Trade Exclusion • Cost to domestic economy • Change in government, finance minister

14. Sovereign Default REMEDY • Adjust economic policies • Taxes • Management of budget deficit • Structural imbalances • Emergency interim funding • IMF plays a key role • Restructure of existing debt • Longer term viability • Often led by IMF review

15. “Many citizens were stocking up for bad times and throughout the country shop shelves were being emptied, leaving a shortage of even the most basic items, such as vegetable oil, sugar or washing powder.”

16. Case Study I From Russia with Love

17. Background Artificially high exchange rate due to pegged currency Asian Financial Crisis Expensive Chechnyan war ($5.5bn) Drop in Demand and Prices for crude oil & non-ferrous metals Main exports of Oil, petroleum, natural gas Metals and timber made Russia vulnerable

18. Start of Crisis Political crisis: Prime Minister fired Cabinet reshuffle Interest rates hiked massively to attract foreign investment (GKO at 150%) Debt on wages grows – impacts major budget items World Bank and IMF $22.6bn package approved to swap GKO for Eurobonds

19. Into Crisis Currency still fixed Miners go on strike over unpaid wages, blocking Trans-Siberian railway Monthly interest payments exceed tax receipts by 40% Left-wing government elements reject government’s crisis plan – another cabinet reshuffle

20. Russian Crisis! Investor confidence evaporates and they flee market Government spends $27 bn to maintain pegged ruble Stock, bond and currency markets collapse on fears of default and ruble depreciation Stock market loses 75% of value Bond yields at 200%

21. Impact of Crisis • Ruble unpegged and moves from 6.43 to 21 ruble / dollar • Inflation reaches 84% in 1998 • Many Russian banks collapse as a result • Local food doubles in cost, imports quadruple • Massive demonstrations in many cities • Cabinet reshuffle • Ultimately, Boris Yeltsin resigns as Russian President • Surrounding economies in the region slow down

22. Recovery • Recovery in oil prices gives Russia a speedy recovery • Budget surpluses in 1999 and 2000 allow debts to be repaid • Domestic industries benefit from devaluation of the ruble • Real economy still highly dependent on barter, so more resilient to monetary crisis • Social and political upheaval contained

23. Case Study II Don’t Cry For Me, Argentina

24. Background 1991 Argentine pesos pegged to the US$ Mid 1990s: US$ appreciates leading to budget deficits in Argentina 1997 East Asian financial crisis 1998 Russia, Brazil and finally Argentina move into recession 1999 Brazil devalues currency, hurting Argentine exports

25. Start of Crisis 1999 Political change: UCR replace the Peronists 2000 IMF $7.2bn aid package announced, based on economic performance targets 2000 Government announces budget cuts to restore economic confidence 2001 Poor economic performances leads to a further $40bn assistance package from IMF

26. Deeper Into Crisis 2001 Minister of the Economy resigns 2001 Voluntary debt restructure 2001 Massive strikes over government austerity measures and lack of economic confidence 2001 Peronist opposition gains control in mid-term elections

27. Argentine Default! 2001 Investor confidence evaporates and there is a run on the banks 2001 Supermarket looting begins, nationwide strikes continue 2001 President and Finance Minister resign. Unstable leadership in government 2002 Debt converted to pesos (devalued) and finally foreign debt payments stopped

28. Impact of Crisis • Argentina default on over $100 billion of debt, the largest default in history • Peso devalued quickly as foreign investment left the country • Pension savings (both local and foreign) lost • Peronist party back in power • Surrounding economies slow down • Debt restructure still on going, but significant payment to extinguish IMF debt ($9bn) made in 2006

29. My Big Fat Greek…Default?

30. Background 2000 - 2007 Greek economy one of fastest growing in Eurozone 2000 - 2007 Flood of foreign capital allows large structural deficits. (>100% of GDP) 2000 - 2007 Deficits used to fund public sector jobs, pensions, social benefits Mid 2000s Greece could devalue currency to limit impact of deficit Mid 2000s Even in Eurozone, lower interest rates for Greek debt allowed deficit to continue

31. Start of Crisis 2008 Global financial crisis impacts tourism and shipping heavily 2009 Budget deficit revised from 6% to 12.7% after consistent misreporting revealed 2010 Budget deficit hits 13.6%, one of the highest in the world 2010 Debt hits 120% of GDP. 70% of debt held externally

32. Euro Crisis

33. Deeper Into Crisis 2010 (Apr/May) Greek government debt downgraded to “junk” status 2010 (Apr/May) Yields on debt shoot to 15.3% 2010 (Apr/May) Stock markets worldwide fall on fears of 30% to 50% haircut on Greek default Greece unable to devalue currency

34. Greek default…averted! 2010 (March) Greek government plan austerity measures and request aid funding 2010 (May) European Central Bank guarantee Greek banks’ access to cheap central funding 2010 (May) Euro 110 billion loan deal between Greece, Eurozone and IMF 2010 Strikes and rioting in response to austerity measures

35. Impact of Crisis • Rapid provision of funding averts default • Creation of the European Financial Stability Facility • Harsh austerity measures … “the party” is over in Greece • Social instability • Austerity measures for other EU member states • Concerns that crisis could spread to rest of Eurozone leads to market volatility and pressure on the PIGS

36. Why Different This Time? Banking System • The bigger concern in Euro crisis was risk of contagion • Contagion means debt crisis in one country worsens or leads to a debt crisis in other countries • Contagion can also affect banks and their debt Sovereign Debt

37. Contagion Risk

38. Contagion • Greece only 2.5% of Euro GDP • Portugal, Ireland, Spain, Italy and even UK vulnerable given high budget deficits and debt to GDP ratios • Greek default would have • Threatened EU states reputation • Destabilised the Euro as they exit the EU • Threaten debt held by EU nations • Which could have had a knock on effect, leading to more defaults

39. Longer Term Implications

40. Longer-Term Implications • Contagion risk has been contained (for now) with bailout and ESFS • But at a great cost: • Austerity measures means populace pays for the debt mismanagement • Countries still borrowing to put together bail-outs and rescue packages, which will put pressure on their economies • Political and social instability due to austerity and debt mismanagement

41. Long-Term Implications Implications for economies & citizens • Structurally slower economic growth ahead as fiscal policy is tightened • Implies structurally higher unemployment & higher dependency ratios • It likely also implies structurally low investment returns • A key focus of fiscal tightening was cutting state financed social benefits, & cutting state financed pension benefits • Calls to raise retirement age to 70 (from average of 61 currently) as pension funds seen as highly vulnerable to collapse Source: Rian le Roux, Chief Economist - OMIGSA

42. Bottom line for affected households • Government’s budget constraints imply people must come to expect the bare minimum social benefits in future • As years (decades?) of fiscal consolidation lie ahead for many countries, people will be increasingly be forced to provide for their own retirement • Likely structurally low investment returns will require a very high level of savings for those on DC funds, DB members face stagnant pensions Have we really fully realised implications? Source: Rian le Roux, Chief Economist - OMIGSA

43. Long-Term Implications • While we are fiscally better off … • Deficit reduction / control will also have priorityi.e. Government will act to ensure we do not land in the same situation • Implications for economies & citizens • Growth will be relatively mediocre (3% - 4%) • Unemployment will remain high • Investment returns will be structurally lower • Social benefits will be curtailed (already 14m people on aid) • Bottom line for affected households • Expect limited growth in social benefits • People will be increasingly forced to provide sufficiently for their own retirement – but, SA retirement age low (55?) & falling? • Likely structurally low investment returns will require a very high level of savings Source: Rian le Roux, Chief Economist - OMIGSA

44. Economic Recovery

46. Managing Risk Identify Assess Mitigate Control

47. Identify & Assess • Analyse your investment risk at the holdings level • Not just manager level • Or Asset Level • Look for exposure to • Foreign currency • Dual-listed stocks • Foreign sovereign debt by country • Foreign corporate debt • Equity • Quantify size of exposure and impact from volatility

48. Mitigate & Control • Consider hedging out risk you don’t want exposure to currently • Use risk budgeting to limit your exposure to risky investments • Be clear on the risk tolerance of your membership and liability profile • Ask for frequent reporting

49. THANK YOU