The Sovereign Crisis:

When Debt is No Longer Risk Free

Washington, DC

January 26, 2012

Important Notice

Proprietary and Confidential

This presentation and any information and discussions concerning its contents, are the proprietary information of the Center for Financial Stability (CFS). Disclosure of this information is accompanied by an obligation

that the recipient receive and hold this information in confidence, and not use or disclose it except for the purposes of conducting business with CFS or except with the prior written permission of CFS.

Copyright © 2012 CFS as an unpublished work. All rights reserved.

Lawrence Goodman President

2

Key Themes -- Distortion

• Policy matters. Advanced economies now embody traits of

emerging markets.

• Prioritize future growth in Europe via a three-pronged strategy

to reduce debt, remove the threat of contagion, and limit the use of

official resources.

• The appetite for Treasury debt is weakening. The refunding of

US Treasury debt presents an equal challenge to the oft-

discussed budget deficits. Fiscal policy is poorly understood in the

US.

• The role of the US dollar as a reserve currency is changing.

• Sovereign debt is no longer risk free even in the US - despite

low yields.

3

Contents

I. The Global Economy and Policy Distortions

II. The European Sovereign Debt Crisis: A Way Out

III. United States: It's the Principal that Matters!

IV. Implications for Reserve Currency Status

V. Concluding Thoughts

4

I. The Global Economy and Policy Distortions

5

Spectrum of Fundamental Drivers: Why Advanced Economies look more like Emerging Markets.

Advanced

Economies

Middle Income

Emerging Markets

Fragile

States

More strictly

ECONOMIC analysis

More strictly

POLITICAL analysis

Economics Politics

6

World Trade: Extreme Policy Response limits

Duration of Recession…Distortions Remain

Source: IMF Direction of Trade Statistics and Center for Financial Stability .

0

200

400

600

800

1,000

1,200

1,400

1,600

Jan-70 Jan-74 Jan-78 Jan-82 Jan-86 Jan-90 Jan-94 Jan-98 Jan-02 Jan-06 Jan-10

US$

Bill

ion

, R

eal

Au

g '1

1

Oil ShockTrade: - 26% in 15 months

Fed Policy ShiftTrade: - 31%in 47 months

Tech BubbleTrade = - 24%in 16 months

US RecessionTrade: - 24% in 27 months

Financial CrisisTrade: - 42% in7 months

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10

Great Recession

Great Depression

1982 Recession

7

Cumulative Deficits in Deep Downturns, % of GDP

Source: Office of Management and Budget, Historical Financial Statistics and Center for Financial Stability .

Strong and Swift US Fiscal

Response: ’08 - ’11

8

Policy Distortions Influence Financial Markets

Source: Datastream, Robert Shiller (Yale University), and Center for Financial Stability .

0

10

20

30

40

50

60

Jan

-62

Jan

-64

Jan

-66

Jan

-68

Jan

-70

Jan

-72

Jan

-74

Jan

-76

Jan

-78

Jan

-80

Jan

-82

Jan

-84

Jan

-86

Jan

-88

Jan

-90

Jan

-92

Jan

-94

Jan

-96

Jan

-98

Jan

-00

Jan

-02

Jan

-04

Jan

-06

Jan

-08

Jan

-10

Pri

ce t

o E

arn

ings

or

Yie

ld-b

ase

d V

alu

atio

n

UST Bond Valuation

S&P Price Earnings Ratio

Average PE = 19.4

9

Fiscal Stimulus and Capacity to Expand

-80

-60

-40

-20

0

20

40

60

80

-45

-35

-25

-15

-5

5

15

25

35

45

Ch

ileSin

gapo

reK

ore

aR

ussia

Can

ada

Au

straliaV

en

ezu

ela

Ecuad

or

Switze

rland

Me

xicoA

rgen

tina

Ind

on

esia

Thailan

dU

SP

eru

Spain

C

hin

aN

eth

erlan

ds

S Africa

Co

lom

bia

UK

Taiwan

Ukrain

eP

hilip

pin

es

Cze

chP

olan

dM

alaysiaG

erm

any

France

ItalyP

ortu

galIn

dia

Brazil

Hu

ngary

Turke

yG

ree

ceJap

an

% o

f G

DP,

Fis

cal

Spac

e

% o

f G

DP,

St

imu

lus

Fiscal Ease 08 - 11 (Stimulus)

Cumulative 95 - 07 (Fiscal Space)

STRONGFiscal Space

orAbility to Spend

WEAK

Source: Datastream and Center for Financial Stability.

10

II. The European Sovereign Debt Crisis:

A Way Out

11

Debt Restructuring: The Way Forward

The Economic Subcommittee (ESC) to Bank Advisory

Committees during the Brady Debt restructuring era provides

a blueprint for:

1) identifying common ground for the benefit of creditors and

debtors alike and

2) paving the way for future growth.

12

New Strategy: Financial Program

Substitute Math for Rhetoric: Lessons from Emerging Markets

Economics - restoring growth for a long-term

solution,

Finance - identifying sustainable levels of debt

and potentially needed support for banks.

Mobilize sovereign and private balance sheets.

Official Institutions - highlighting available official resources to support and ensure implementation of a successful program.

13

Economic Growth Improvement Post Debt Reduction

Note: Brady Deals include Mexico (1990), Venezuela (1990), Argentina (1993), Brazil (1994), Dominican Republic

(1994), Bulgaria (1994), Poland (1994), and Ecuador (1995).

Source: Datastream, IMF and Center for Financial Stability.

-8

-6

-4

-2

0

2

4

6

8

Dom Republic

Poland Argentina Venezuela Mexico Brazil Ecuador Bulgaria

Ave

rage

An

nu

al %

5 years BEFORE Brady Plan

5 years AFTER Brady Plan

-40%

-30%

-20%

-10%

0%

10%

20%

30%

GRD PTE IEP BEF NLG ESP ATS FRF DEM ITL EUR FIM

1990 to euro entry

Euro entry to October 2011

Cumulative

14

Component Currency Strains in the Euro

Note: The CFS real exchange rates incorporate 48 nations with calculations from January 1990 to October 2011.

Source: International Financial Statistics, Direction of Trade Statistics, and Center for Financial Stability.

Real Appreciation /

Overvaluation

Real Depreciation /

Undervaluation

15

III. United States: It’s the Principal Matters!!!

Despite legitimate concerns regarding the budget deficit,

large refinancings of debt represent an equally severe – yet

lesser known challenge. The experience of Emerging

Markets and some advanced economies suggests that…it is

the repayment of principal that often triggers a crisis rather

than simply the size of the debt or deficit.

From: “Treasury Maturities: The Other Fiscal Problem”, March 10, 2011

(http://www.centerforfinancialstability.org/research/USFiscal031011.pdf)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1973 1978 1983 1988 1993 1998 2003 2008

Mat

uri

ng

De

bt,

% o

f G

DP

Average (1973 - 2007) Fiscal Surplusesreduced

refuning needs

Low and Stable Refunding Demands on Treasury Market

Surge in Treasury Debt Rollovers

16

USG Debt Maturities Spike in Coming Year

Note: Interest bearing public debt held by private investors.

Source: US Treasury and Center for Financial Stability .

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

<1y 1-5 5-10 >10

% o

f To

tal

Mat

uri

tie

s

1946

2010

Post WWII

Today

17

More Dangerous Treasury Debt Profile

Note: Interest bearing public debt held by private investors.

Source: US Treasury and Center for Financial Stability .

Although

US public

debt-to-

GDP was

higher after

the post-

WWII

period, the

profile of

maturing

obligations

was much

safer!

18

Funding the US is Misunderstood: Example of Conventional Wisdom

Blinder’s myth “that America's deficit problem is so acute

that government spending must be cut right now, despite the

struggling economy. And any fiscal stimulus, even the

payroll-tax extension, must be "paid for" immediately.”

“Wrong. Strange as it may seem with trillion-dollar-plus

deficits, the U.S. government doesn't have a short-run

borrowing problem at all. On the contrary, investors all over

the world are clamoring to lend us money at negative real

interest rates. In purchasing-power terms, they are paying the

U.S. government to borrow their money!”

From: “Four Deficit Myths and a Frightening Fact” by Alan S. Blinder – The Wall Street Journal,

January 19, 2012.

-400

-200

0

200

400

600

800

1000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Bill

ion

s o

f U

SD,

qu

arte

rly

figu

res,

saa

r, 4

qtr

MA

Private Sector

Foreign Sector

Federal Reserve

Private and foreign demand for US Treasury

Bonds falls sharply.

Purchases of US Treasury Bonds by the Federal Reserve supports demand.

19

Who is “clamoring” to lend to Treasury? Net Purchases of Treasury Securities

Source: Federal Reserve, Flow of Funds Accounts and the Center for Financial Stability.

Answer:

The Fed

Fed purchases

of Treasury

bonds distort

market

relationships

(see pg 8)

leading to

potentially

unintended

risks.

20

Foreign Private Sector: Duration Preferences

Source: Treasury International Capital (TIC) reports and the Center for Financial Stability.

-200

-100

0

100

200

300

400

500

600

700

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

Bill

ion

s o

f U

SD,

ann

ual

, 1

2 m

on

th s

um

Bond & Notes Bills

Early in the Crisis, the foreignprivate sectorpurchased

short and longterm Treasury obligations.

QE1: Fed to purchase to $300bn UST and to $1,250bn MBS (3/18/09)- the Foreign private

sector swiftly alter its purchases.

As the EuropeanDebt Crisis worsened,the foreign private sectorshifted to short versus longterm Treasury obligations.

21

Foreign Governments: Duration Preferences

Source: Treasury International Capital (TIC) reports and the Center for Financial Stability.

-200

-100

0

100

200

300

400

500

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11Bill

ion

s o

f U

SD,

ann

ual

, 1

2 m

on

th s

um

Bonds & Notes Bills

Early in the Crisis, foreign governments favored short over longterm Treasury obligations.

QE1: Fed to purchase to $300bn UST

and to $1,250bn MBS

(3/18/09) -Foreign central

banks alter purchases.

Despite the European Debt

Crisis, purchases of US Treasury bills, notes, and

bonds drift lower.

-10%

-5%

0%

5%

10%

15%

20%

Jan-0

0

Jan-0

1

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

Year

-ove

r-Ye

ar

M1 - CFS Divisia

M4 - CFS Divisia

22

Limits to the Fed’s Quantitative Easing (QE)

With thanks to William Barnett, Director of Advances in Monetary and Financial Measurement and Jeff van den Noort Chief

Technology Officer at the Center for Financial Stability.

Source: Federal Reserve, other official, bank rates, and the Center for Financial Stability.

23

IV. Implications for Reserve Currency Status

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

55%

57%

59%

61%

63%

65%

67%

69%

71%

73%

75%

Q1 1999 Q1 2001 Q1 2003 Q1 2005 Q1 2007 Q1 2009 Q1 2011

% o

f To

tal

Ho

ldin

gs,

Oth

er

Cu

rre

nci

es

% o

f To

tal

Ho

ldin

gs,

USD

USD - left axis

Other Currencies - right axis

Constant drop in USD holdings Surge in Holdings of "Other" Currencies

24

Reserve Currencies: Shifting “Stores of Value”

Note: Composition of World Central Bank Reserves. “Other” is largely AUD, CAD, NOK, SEK and NZD.

Source: Datastream, International Monetary Fund (COFER) and Center for Financial Stability.

25

Concluding thoughts…

• Sovereign debt is no longer risk free even in the US, where

Fed purchases mask signals from market interest rates.

• Reserve currency competitors are surfacing.

• Refunding risk presents an equal challenge to large budget

deficits. There is not an infinite appetite for Treasury bonds.

• The European crisis would improve from a strategy to reduce

debt, remove the threat of contagion by balance sheet action, and

a limited use of official resources.

• Policy matters more than ever for advanced economies.

26

About CFS and Disclosure

The Center for Financial Stability (CFS) is a private, nonprofit institution focusing on global finance

and markets. Its research is nonpartisan.

The CFS is dedicated to the integration of finance, law, and economics. The organization is unique,

as it focuses on market mechanics and linkages while serving as a private sector check on

government actions.

This publication reflects the judgments and recommendations of the author(s). They do not

necessarily represent the views of Members of the Advisory Board or Trustees, whose involvement

in no way should be interpreted as an endorsement of the report by either themselves or the

organizations with which they are affiliated.

The organization’s website is www.CenterforFinancialStability.org.

The Center for Financial Stability is a non-profit 501(c)(3)

organization formed for educational purposes.