Editor's Note: This is Part 2 in a multiple-part series. Part 1 can be found here.

Government Largesse

A key risk remains in the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession, and bailout packages for banks and other “worthies” means that many countries face large and continuing budget deficits.

Even countries with relatively healthy balance sheets, such as Australia, don’t anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public-sector pensions, health care, and social security arrangements are included, then the budgetary position looks considerably worse.

Debt, Debt, Everywhere; No Repayment in Sight

In 2009, total sovereign debt issues are expected to total over $5 trillion of which the US alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing: US is around 300%, UK is over 400%, Euro Zone is around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.

Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP).

As a comparison, the total amount of global investment assets under management according to one estimate is around $120 trillion. This provides some idea of the funding task ahead.

To date, sovereign-debt issuance programs have been successful. There have been some auction problems (in Germany, the UK and the US), but they’ve been manageable.

Long-term interest rates have risen sharply, reflecting supply pressures. The US 30-year rate has increased by around 1.50% p.a. since the start of 2009. Maturities have also shortened increasing the refinancing challenges ahead. Participation of central banks in the US and the UK bonds, under their quantitative-easing mandates, has helped keep interest-rate rises down, creating a somewhat artificial market.

A key issue over the coming months is the continued demand for increased sovereign-debt issues. China, Japan, and Europe historically have been major buyers of US Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China’s foreign-exchange reserves are growing more slowly than before. China has continued to purchase US Treasury bonds, but some purchases represent a switch from US Agency paper. As the US has increased its issuance program, China’s purchases are now a smaller portion of the total