As the sovereign debt crisis in Europe continues to deepen, the Bank for International Settlements has warned that similar problems may strike a broader range of countries in the future. High fiscal deficits and rising pension and healthcare costs are likely to increase government debt levels in advanced economies, while emerging markets remain vulnerable to external supply shocks and political instability, the BIS said in a paper published this week.
“Overall, risk premia on government debt will likely be higher and more volatile than in the past. In some countries, sovereign debt has already lost its risk-free status; in others, it may do so in the future.”
In Europe, officials are working to contain the knock-on affects of rapidly declining sovereign quality across the southern eurozone. Banks in Greece, Portugal and Ireland have become reliant on central bank liquidity, while an increase in the cost of wholesale funding has spread to other European banks.
The problem is multi-fold, the BIS concluded: losses on holdings on government debt weakens’ bank balance sheets, while higher levels of sovereign risk reduces the value of collateral banks can use to raise wholesale funding and central bank liquidity. Sovereign downgrades can also flow through to lower credit ratings for domestic banks, further increasing their funding costs.
The BIS warned that while the US, the UK and Japan had so far been less affected by sovereign risk concerns, they were not “immune,” given their sharp increase in public debt ratios in recent years.