Worst-case scenarios now focus on G7 govt risk

By Jane Baird

LONDON, Jan 16 (Reuters) - Loss of confidence in a G7 government bond market, a major currency in freefall, runaway inflation -- such extremes are among possible scenarios under discussion by some credit analysts as government risk rises.

After 18 months of relentless financial shocks, bank implosions and dramatic bailouts, some analysts are wary of being blindsided again as they prepare outlooks in the new year.

They are, therefore, considering possibilities that would have been deemed unthinkable only a year ago.

"2007 was the year of the subprime crisis. 2008 was the year of the financial crisis. 2009 will be the year of the economic crisis. Will 2010 be the year of the currency crisis?" said Philip Gisdakis, a credit strategist with UniCredit (HVB).

Western governments are injecting trillions of dollars, euros or pounds to prop up economies and bail out banks, and fears are growing that the creditworthiness of the states themselves is deteriorating as a result.

"The (corporate) defaults that would happen under a free market will be largely absorbed by government (debt) issuance and money printing," Deutsche Bank credit strategist Jim Reid said in a recent note to investors.

The cost of buying protection in the credit derivatives market against a U.S. government default for five years, for example, has risen to around 61.5 basis points from 1.47 basis points at end-2006, according to data from Markit, meaning it costs $61,500 a year to protect against the default of $10 million worth of debt.

"The biggest risk remains not over the willingness to intervene but the ability ... if 2009 goes horribly wrong, it's probably because there's a destabilising run on a major currency or a government bond market," Reid wrote.

"Let's hope the authorities get it right and that by 2010 we won't be talking about the risks of depression or even hyperinflation!"

On Friday, Ireland's debt looked riskier as five-year credit default swaps rose to a record after the government nationalised Anglo-Irish Bank.

While Ireland shares the euro currency with much bigger economies, the North Atlantic island of Iceland had to turn to the International Monetary Fund last year for help after its national currency plunged and its financial system collapsed under billions of dollars of foreign debt.

MOST VULNERABLE OF G7

Of G7 countries, Britain is seen as most vulnerable. The country is suffering the consequences of a debt-fuelled boom in asset prices and spending, which relied on short-term funding from abroad.

It must go through a stretch of deleveraging and economic contraction, while foreign demand for its assets falls and the government deficit, already at post-war records, swells.

The pound has already fallen 26 percent against the dollar since end-July, and any boost from cheaper sterling will be limited by the UK's small manufacturing base and its reliance on exports of financial services, demand for which is plummeting.

Michael Saunders, Citigroup's UK economist, expects low interest rates and a sharp rise in unemployment as the economy crashes, with recovery maybe in 2010 or 2011.

That is his base case, but Saunders also warned in a recent report of the potential for "a surge in inflation expectations and total collapse of confidence in UK policymakers' commitment to economic stability".

Asked about this scenario, he said it was not the most likely outcome but he did not want to put a more precise probability on it.

"I am conscious that, over the past year, some of the disintegration of the market involved events that in hindsight seemed possible," he said. "All the ingredients were there."

"This makes me reluctant to say that I know this (dire scenario) is only a remote risk," he added.

Five-year CDS on UK government debt have risen to around 125.5 basis points from 1.99 basis points at end-2006. By comparison, five-year CDS on UK confectionary maker Cadbury Plc are only about 61 basis points.

But UniCredit's Gisdakis said Britain at worst still has a way out -- joining the euro, a currency for which inflation is not a worry. Five-year CDS on German government debt have risen to a relatively low 53.5 basis points from 1.84 at end-2006.

While the risks of currency meltdown and runaway inflation are valid topics of discussion, Gisdakis said, the fear is not around the extremes of 1920s Germany so much as a scenario like the 1970s with double-digit inflation.

Other analysts play down that risk.

Binit Patel, Goldman Sachs's international economist, assured investors recently their fears that policymakers were risking inflation were unjustified, because "world growth is unlikely to expand rapidly enough." He saw only a small risk after economies begin to recover.

Jochen Felsenheimer, co-head of credit for risk management firm Assenagon, warned of a risk for investors in being too pessimistic and missing out on the current opportunities in corporate bonds, even while he expected a sharp economic downturn in 2009 and 2010.

"Everyone is very bearish now, and that's a good sign that things are not so bad," Felsenheimer said.

(Reporting by Jane Baird; Editing by Ruth Pitchford)