When governments default

In developing economies, the domestic banks tend to underwrite the government's activities - so that in the event that a government defaults on its borrowings, this can lead to insolvency within the banking system.  In economies like our own, circumstances tend to work the other way around - the government in effect steps in to underwrite the insolvent state of our domestic banks, which in turn puts stress on public finances, which then leads to an increased risk of governmental default.  You have probably read recently about the concerns raised by credit-rating agencies in relation to Alister Darling's recent bond-issuance activities.

It would be wrong to think that it is only in basket-case economies where the government ends up defaulting on its borrowings.  Clearly, we have examples such as Argentina which last defaulted in 2001, the fifth time since independence - but France and Spain have a chequered career historically, with China, Germany and Russia performing this trick several times in the 20th Century.  In fact, out of the leading industrial nations, only the US, UK and Canada have not previously defaulted - although the stratospheric rise in public sector debt increases the risks for our own economy.

Now, it's not very likely that either we or our clients will be investing in third world debt, so how can these concerns impact upon our financial advice?  Currently, the eurozone countries which are most likely to default are: Portugal, Ireland, Greece and Spain (PIGS), and Ireland is top of that list, largely due to the cost of insuring Irish debt against default.  The Irish government's guarantees for its six banks totals $600 billion - or $200,000 per employed person in Ireland.  With unemployment rising significantly, this is one blank cheque which could never be written.  At the risk of wearying you by reiteration - the Irish compensation scheme is not funded, and does not have the money to hand to protect depositors: this is, by anyone's standards, a proverbial House of Cards.

It is worth noting that two of the Irish banks are not covered by the UK's Financial Services Compensation Scheme - these are the Bank of Ireland (including Post Office accounts) and the Anglo Irish bank.  As things stand, it appears as if UK savers have absolutely no protection whatsoever if they have deposits with these two institutions - and it would not be reasonable to expect the UK government to offer pledges in this context (although regulated firms will pay for it via the FSCS Levy!).

Our advice to advisers, and therefore their clients:

• be careful with offshore deposits
• avoid government bonds
• avoid Irish bank deposits
• it may be a good time for gold (recent dip in price)
• invest in decent businesses, via well-established, risk-graded equity funds with a consistent track record

By the way, you've probably read that UK pension scheme defecits now stand at £250Bn.  It may interest you to know that the BOE pension fund has bucked the trend - having sold all of its stocks and bought government bonds at the top of the bull market.  Recently, the BOE have announced that they have now sold out their government bonds and by the end of 2008 were 70% in index-linked gilts.  Perhaps they're a tad premature, but this approach reeks of a savvy investment strategy - what are you doing with your clients?