Start smelling the chocolates

The intelligent investor, managing director of Bedlam Asset Management, Jonathan Compton, says will look forward not back. Instead of reporting on the rescue of those countries already defaulting, he believes Belgium could be the next nation to default.Most investors suffer the common delusion that they are part of the media, with a need to report the news – what has happened? Thus many investment managers are reporting on recent financial crises and the rescue of Greece, Spain and Portugal. By contrast, the intelligent investor looks forward. What country or which countries will default next?

Understanding the sovereign default cycle is not hard. It follows a pattern little changed since the Middle Ages: excess debt – a banking crisis – loss of confidence – then default.

The difficult part is not analysing the numbers, but the soft issues, such as politics, culture or xenophobia; for reliance on hard numbers alone, without overlaying these aspects, will give the wrong answers.

The number of countries defaulting is certain to rise on two measures from the recent two-century low. And on our analysis, one country is a stand-out.

On the numbers alone, the most likely casualties are the UK and US – but both have good odds of escaping. Many hard issues help. In America, one is the dollar’s currently irreplaceable role as the world’s reserve currency. In the UK, the relatively excellent debt duration (i.e. it is spread over many years rather than near-term) is a plus.

Each also has good soft issues: the market likes the new British Government’s tax and slash policies so is a willing buyer of UK debt, while the Asian central banks have so many US bonds they simply self-destruct if they refuse to keep buying.

No, the standout surprise candidate for sovereign default by the end of 2012 is Belgium. A decent country; civilised, at peace, wealthy and globally competitive in several areas.

Moreover, with net government debt of €400 billion, it is hardly a huge world borrower in absolute terms. Yet default could occur almost entirely by accident and the ripples far greater than its size warrants because of its position as the de facto federal capital of the EU.

Belgium is a federation of three states: Flanders in the North, where Dutch (Flemish) is spoken by the native Flemish; Wallonia in the South where the official language is French; and thirdly the all-important region of Brussels.

The linguistic divide is well-known. And it is aggressive: 10 metres either side of the official linguistic border, the other language does not exist. This draconian legal divide was foolishly legislated into place in 1980 and has become more intolerant since. Belgian politics are so culturally divided that all 12 of the major parties break down on linguistic lines and cannot stand in the other language area.

Initially, the Walloons (French speaking) were economically dominant, based on heavy industry. The Flemish-speakers developed into a distinct but majority underclass.  By the early 1970s, the wheel turned. Today, 75 per cent of GDP is accounted for by the service sector where the Flemish dominate and as heavy industry withers. The relative wealth of the Flemish is overwhelming. Their income per head is 118 per cent of the EU average – the French-speakers 85 per cent. Per capita productivity is 20 per cent higher. They make up over 70 per cent of the skilled labor force. Walloon unemployment is twice that of the Flemish.

This economic divide reflects in the country’s politics. The most heated debates in parliament concern two issues: language superiority and the Walloons demanding, and to date getting, an ever greater and disproportionate share of the welfare pie, something deeply resented by the Flemish.

The result is net government borrowing equal to 100 per cent of GDP. Not quite as bad as Greece and a few other miscreants, but add a budget deficit of 6 per cent of GDP and too-high a structural deficit, and Belgium is in the top fifth of over-borrowed nations globally, a position it has steadfastly maintained for the past 30 years.

High debt and gradual linguistic separation have been a constant for 30 years. The recent elections confirm the trend of accelerating separatism. Yet these are likely to morph faster than expected into a financial problem because of Brussels.

Brussels is the de facto federal capital of the EU. It is wealthy, with income per head 233 per cent above the EU average. Since the early 1950s treaties presaging the EU, money has poured into Brussels. But this money spigot is about to jam. Why?

Quite simply, those European countries that are net contributors to the EU are about to turn off the taps. Having been forced to slash their own capital, social, and welfare budgets following the financial crash, they will not put more into Brussels. It is a matter of time before each country decides to reduce its payments to Brussels organisations; hence the second most important engine of Belgium’s economy (after the wider economy of Flanders) suffers its first-ever post-war squeeze.

Moreover, Brussels is no longer so logical a geographic centre for a federal capital since the EU expanded eastwards. Germany is eyeing NATO. France would murder to get its hands on more EU institutions. These changes will take time; turning off the money spigot is easier and will happen sooner.

So how will it play out? There is a growing risk of a faster than expected dissolution of Belgium that will result in sovereign default; this is based on a belief in the inability of the individual nations within the Euro zone, let alone the EU institutions themselves, to realise that as nations unravel, speed is of the essence.

The net €400 billion national debt is chicken feed – less than half the loss racked up by America’s AIG in 2007-8. But other EU countries (especially Germany) have discovered that small cash subsidies to the profligate, such as Greece, are very expensive electorally. So foot dragging and evasion are sure to be the political order of the day. As the divorce commences, little is gained in double-guessing the next phase.

Whether Flanders goes alone as a fabulously rich small state or joins with Holland (now the religious issue is moribund) is a moot point. Equally, whether France chooses to absorb Wallonia into greater France or to subsidise Wallonia as a client state again is also an unknown. On every topic, there is no agreement on how these regions should evolve, nor who is responsible for the debts, further ensuring delay.

If markets have re-learned one lesson recently, it is that small events have disproportionate results. Belgium ranks as the world’s 20th economy by size, accounting for 0.8 per cent of world GDP. Greece before the fall was 28th, with 0.6 per cent; its problems continue to shake markets, both because they were unexpected and because of the risk of a domino effect. So too would be the problem with Belgium. It is yet another reason why government bonds are toxic and why at some stage their yields will blow out, and their capital values fall.

For Belgium is yet another example, as if one was needed, that the supply of government bonds over coming years will continue to soar to unprecedented levels. Meanwhile, equities will benefit.