The new normal implications of sovereign debt and the competition for capital

Some of the themes addressed in the report include: • Guarded optimism about industrialised North American and Asian economies over the next 12 months • Decoupling of European prospects

The New “Normal”

Implications of Sovereign Debt and the Competition for Capital

Table of Contents

+ Investor appetite for sovereign debt 8

Postponing the inevitable: An interview with Carmen Reinhart 11

Sophos exploits the thawing of the private equity market 13

+ Regulation and credit availability 17

About RBC Capital Markets

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we provide our capital markets products and services from 75 offices in 15 countries and work with clients through operations

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About The Economist Intelligence Unit

The Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher of

The Economist Through its global network of 650 analysts, it continuously assesses and forecasts political, economic and business conditions in more than 200 countries As the world’s leading provider of country intelligence, it helps

executives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trends and business strategies

Printed June 2010

Our clients are operating in unprecedented times – what many are calling “the new normal” This environment of high frequency change and evolution is challenging institutional investors and corporate executives to understand, as never before, the derivative implications of complex global economic issues when making important capital allocation decisions for their organizations At RBC Capital Markets, we strive to provide our clients with relevant information and a unique perspective to help them make the best decisions possible.

With this goal in mind, we partnered with the Economist Intelligence Unit to embark on our second poll of over 400 capital markets participants

to specifically address sovereign risk and the outlook for global investors and corporates We launched our survey on April 28, 2010 – concurrent with the beginning of the most volatile month of the European debt crisis – and received responses through the end of May

This white paper is the result of the survey work conducted in the midst of this crisis It reveals interesting insights regarding the impact of recent financial, economic and fiscal events on future financing and investing decisions of corporate and institutional leaders

Some of the themes addressed in the report include:

• Guarded optimism about industrialised North American and Asian economies over the next 12 months

• Decoupling of European prospects for currency, fiscal solidarity and economic growth from global peers

• Long-term capital availability concerns for sovereigns and a cautionary approach from corporates in light of risk reorientation

Paul Abberley, Chief Executive, Aviva Investors

Paul Corcoran, Financial Director, Nord Stream

James Douglas, Head of Debt Advisory, Deloitte

Teddy Moynihan, Partner, Oliver Wyman

Steve Munford, Chief Executive Officer, Sophos

Shaun Parker, Chief Financial Officer, CPP

Carmen Reinhart, Co-Author of This Time Is Different

Robin Stalker, Chief Financial Officer, Adidas

Ian Winham, Chief Financial Officer, Ricoh Europe

Theo Zemek, Global Head of Fixed Income, AXA Investment Managers

We hope you will find the report insightful

Co-Head of Global Research Co-Head of Global Research

Foreword

As part of this research program, RBC Capital Markets commissioned the Economist Intelligence Unit to survey 440 capital markets participants

on the effects of the recent financial, economic and fiscal events on borrowers and investors The online survey was done over a period of four weeks, from April 28 to May 25, 2010, a time of massive market volatility and constant headlines on a potential Greek default (see below)

Headlines over the time period About the survey

ECB dashes rescue hopes

EU, IMF stitch together

€750bn emergency fund; IMF to disburse

€5.5bn now

Greece gets

€14.5bn loan from EU

IMF chief economist says Greek aid package doubts remain

• Respondents were almost evenly split

between financial institutions (229 or

52%) and non-financial corporations

(211 or 48%)

• Among the financial institutions,

27% were commercial banks, 20%

investment banks, 19% asset

managers, 16% private equity firms,

10% hedge funds and 8% pension

funds, sovereign wealth funds or other

institutional investors About one-third

had over $150bn in assets, while

60% had over $10bn.1

• The corporates came from a wide

range of industries, with six sectors

accounting for 61%: healthcare

and pharma, professional services,

manufacturing, technology, energy and

natural resources, and retail

Three-quarters had over $500m in annual

revenues and about a third had over

$5bn

• The largest group of respondents,

41%, was from Europe, followed by

North America (34%) and Asia-Pacific

(16%) The remaining 9% were

from Latin America, the Middle East

or Africa

• The executives polled were

a senior group, with 38% at the

C-level and 61% at or above

the VP or director level The rest

were heads of business lines,

departmental heads or managers

1 All $ figures are USD$ unless

otherwise noted.

Market activity during the survey window

The timing of the survey coincided with a period of extreme volatility visible in most market indicators.

Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1

Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1

Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1

As one crisis leads to another – first financial, then economic, now fiscal – market participants struggle to discern the shape of the next big wave Investment-grade capital providers and borrowers have plenty of cash and the ability to get more But in terms of perceptions and performance, the gap between high-quality borrowers and others – companies, sovereigns or even entire industries – has seldom been wider And capital providers need to remain vigilant in light of continuing writedowns and regulatory challenges that could reduce their financial flexibility

Demand for funding is low today, but competition may well grow more acute The scale of debt issuance required by governments and financial institutions over the next few years will be almost without precedent As demand grows, any institution seeking to raise capital will face more selective and critical investors The euro is not likely to recover soon; sovereigns in developed nations will need years to repair the fiscal damage To succeed in this environment, borrowers will require strong, long-term relationships and the ability to construct a convincing argument for their prospects in a volatile environment

At the end of 2009, the global economy was showing strong signs of recovery Major economies had emerged from recession, equity markets had enjoyed

a sustained boom, trade was flowing again, and corporate profitability had returned after companies had slashed costs Even the major investment banks

at the epicentre of the crisis enjoyed a strong rebound and posted significant increases in revenues and profitability

But despite a growing sense that the worst is over, serious problems continue

to bubble up The economic recovery is uneven, with emerging markets leading the way and industrialised countries constrained by damage to the financial sector Banks are in better shape than at the start of 2009 but continue to

be severely impaired, particularly in Europe And unemployment remains stubbornly high in many OECD countries, constraining consumption and prompting further fears of defaults on loans

But perhaps the most severe challenge is the indebtedness of many industrialised countries The massive transfer of debt from the private sector

to the public sector, along with an unprecedented fiscal and monetary stimulus from the world’s major industrialised economies, has led to a dramatic deterioration in public finances As the OECD notes: “Many countries are facing very unfavorable government debt dynamics, as rising indebtedness raises risk premia, which adds to the debt burden while holding back growth, which has further adverse consequences on debt sustainability.”2

2 OECD Economic Outlook

No 87, May 2010

“The lesson of history,

then, is that even

matter how rich she

starts out, a financial

system can collapse

under the pressure

of greed, politics and

Key survey findings

Financial institutions and corporates are

guardedly optimistic about the prospects

for economic growth

> Respondents expect growth-friendly monetary (if not fiscal) policies over the next three years

> Despite strength in the emerging markets, growth in the developed nations will remain below historic norms

> Respondents expect the prospects for industrialised Asia and North America to improve over the next

12 months

The economic prospects for Europe appear

to have decoupled from those of other

> One-third see at least a 25% chance of a complete break-up of the eurozone over the same period

> Problems facing the euro have reinforced the position

of the dollar as the international reserve currency of choice

The European sovereign debt crisis has

caused a reorientation of risk

> There are concerns that governments of developed countries will not have sufficient credit capacity for the massive intervention required to kick-start their economies in the event of another financial crisis

> Sovereign debt is not alone in being perceived as more risky: respondents think all asset classes have become riskier as a result of the financial crisis

> A small majority of respondents expect yields on bonds from the most creditworthy corporates to fall below those of sovereign benchmarks over the next three years – corporates, suggest these respondents, are the new sovereigns

Economic uncertainty is deterring corporates

from raising capital

> Just one-third of corporates say that they plan to raise capital over the next 12 months

> For companies that do plan to raise capital, investment-grade debt and private equity are the most popular categories

> There is a mismatch between expectations of financial services and corporate respondents; the former are more optimistic about the outlook for transaction volumes than the latter

> More than half of companies have restructured their business operations to improve access to capital

Although the actions of policy-makers around the world have been effective in dealing with the short-term problems of the financial crisis, many commentators continue to worry that the underlying problems remain unresolved “Policy-makers essentially took a private sector debt overhang and nationalised it,” says Paul Abberley, Chief Executive of Aviva Investors “The response to the financial crisis has delayed a reckoning rather than solving the problem and getting us back

to normal.”

While corporates and investors expect a return to growth, the adverse economic headwinds continue to weigh heavily on their minds Among the survey respondents, 87% think that economic growth will be positive over the next two years, but only 5% expect it to exceed levels seen in 2003 to 2007 There is a strong consensus that growth will be driven by policy intervention rather than an improvement in the economic fundamentals The number of respondents who agree that central banks will continue to prop up the economy and financial sector rather than fight inflation exceeds the number who disagree by 44% (see Chart 1).Respondents also foresee a divergence between developed and undeveloped markets Many more respondents agree than disagree with the assertion that economic growth and consumer demand in developed countries will remain well below the post-war norm (see Chart 1) We find similar levels of agreement with the statement that faster-growing nations such as China and India will replace the U.S

as a source of import demand driving global growth.3 To use a phrase borrowed from Mohamed El-Erian, CEO of PIMCO, this is the “new normal” of “muted growth overall,

a protracted need for balance sheet rehabilitation, accelerated migration of growth and wealth dynamics to systemically important emerging economies and relatively weak global governance”.4

3 For instance, China’s spending on

imports rose 48% year-on-year in

May and India’s imports 43% in April

4 PIMCO Secular Outlook, May 2010

Central banks will continue to prop

up the economy and financial sector rather than fight inflation Even after income, credit and confidence return, U.S consumers will not spend at

historic peak levels Economic growth and consumer demand in developed economies will remain well below the

post-war norm Faster-growing nations will replace the U.S as a source of import demand driving global growth

Chart 1: Positive albeit modest growth prospects

Demand and growth over next 3 years (agree minus disagree)

Respondents were given choices of agree, disagree, neutral or don't know/no opinion The chart shows the percentage choosing "agree" less those choosing "disagree." It does not show those choosing "neutral" or "don't know/no opinion."

But although growth prospects are

polarised between industrialised

and emerging economies, there are

important nuances While respondents

undoubtedly see Asia as having the

best economic prospects over the next

12 months, North America is close

behind in terms of levels of optimism

The outlier is Europe, which many

more respondents think has a negative

outlook than a positive one (see Chart 2)

Essentially, survey participants’

perceptions of Europe’s economic

outlook appear to have decoupled

from their perceptions of the rest of the

industralised world

Chart 2: Europe’s lack of expected growth contrasts

with the rest of the world

Economic prospects over next 12 months by region (better minus worse)

-40% -20% 0% 20% 40% 60% 80% Europe

Japan Africa Middle East Russia North America China

Other developed Asia (Hong Kong, Singapore, South Korea)

India

CPP – The IPO markets re-open

In the first quarter of 2010, there were 100 IPO deals

globally, making it the best quarter for issuance since

the end of 2007 CPP, an insurance company providing

protection against credit card and identity theft, was one

beneficiary of this trend In March 2010, it raised £150m

(US$220m) on the London Stock Exchange through an IPO

that valued the company at £396m (US$581m) Although

the shares were priced at the lower end of the expected

range, the IPO is a sign of growing investor appetite to

participate in new offerings

The IPO took place before the eruption of sovereign debt

problems, but there was still considerable volatility “As we

went into the process there were good weeks and bad weeks

in the financial markets,” says Shaun Parker, Chief Financial

Officer of CPP “At some points things looked bad and then all of a sudden the market would firm up again So it was a period of considerable volatility but still within a reasonable boundary that led us to feel comfortable about the timing.”

A number of other companies cancelled offerings due to market volatility or lack of demand The key to success, according to Mr Parker, is to ensure that the company has strong financial fundamentals before going to market

“We’re a business with a growth story and we’ve proven that over a relatively long period of time,” he explains “We also generate cash, which means we can pay out a pretty strong dividend I believe that if the fundamentals are there and investors have money to invest, then they will be willing to get involved.”

Respondents were given choices of better economic prospects, worse economic prospects, no change or don’t know/no opinion The chart shows the percentage choosing “better prospects” less those choosing “worse prospects.” It does not show those choosing “neutral” or “don’t know/no opinion.”

Sovereign debt: crisis and change

Although few industrialised countries can boast a positive

fiscal outlook, the problems have become most acute on the

periphery of the eurozone In December 2009, Greece’s credit

rating was downgraded to the lowest in the eurozone as a

result of concerns over its ballooning debt Despite promises of

“austerity measures” comprising public spending cuts and tax

increases, Greek bond yields jumped to unprecedented levels

Fears grew that other indebted members of the eurozone –

Portugal, Spain, Italy, Ireland, even France – faced problems on

a similar scale Despite a €750bn rescue package announced

in late May by eurozone finance ministers, concerns about a

potential Greek default, and indeed for the future of the entire

eurozone, persist “The bail-out failed to reassure the markets,

but I think it would have been impossible at an institutional

level to move any faster than the governments actually did,”

says Mr Abberley

The problems facing the eurozone have raised questions as to

whether the euro can survive the crisis Almost half of survey

respondents think there is a greater than 50/50 chance of one

or more countries leaving the eurozone in the next three years

(see Chart 3) More worryingly, about one-third see at least a

25% chance of a complete break-up of the eurozone over the

same period (see Chart 4)

Part of the problem has been that peripheral countries have built up fiscal deficits that massively breach the eurozone’s targets of 3% of GDP But a deeper problem has been a monetary union achieved without fiscal or political union

“I genuinely cannot see how in the longer term the euro can last in the form that it is in, unless there is greater fiscal and political centralisation in Brussels,” says Theo Zemek, Global Head of Fixed Income at AXA “And the implications of that are

so onerous that I do not believe it will ever happen.”

Investor appetite for sovereign debt

In 2009, sovereign debt issuance surged to record levels in the U.S., U.K and eurozone as crisis-related interventions led to a dramatic increase in borrowing requirements This huge transfer of debt from the private to public sector raises the question of whether institutional investors will have the capacity or willingness to absorb the supply of new sovereign debt issuance

Among the survey respondents, significantly more agree than disagree with the assertion that the credit capacity of developed countries will diminish significantly compared with capacity today (see Chart 5) Respondents agree even more strongly that developed countries will not stop

Chart 3: Survey respondents estimate the odds of one or more countries leaving the

eurozone in the next three years

Chart 4: Survey respondents estimate the odds of the eurozone breaking up in

the next three years

a 25% probability

increasing their levels of indebtedness until investors force

them to scale back on debt purchases (see Chart 5) In

short, even supposedly “safe” sovereigns could experience

a shock if they do not restore fiscal discipline and bring

down deficits

For now there is sufficient appetite for sovereign debt

issuance, even if the conditions may not be to everyone’s

liking “Everything can be digested under certain scenarios

– it is just that some are more pleasant than others,” says

Professor Reinhart “There will be costs You cannot take

current interest rates as a given in this kind of scenario

because the issuance by the major parties is so huge.”

Longer-term prospects

Despite price volatility, sovereign assets have a good deal

going for them over the long term Banks are likely to hold more

sovereign debt to meet new rules on capital adequacy and

liquidity Basel III will heavily weight government bonds on the

asset side, leading to higher demand for sovereigns Moreover,

banks have learned the importance of holding assets that can

be sold quickly and easily As the most liquid asset class by far,

A persistent risk aversion among investors also suggests higher allocations to bonds despite a reassessment of sovereign debt “In one form or another, pension funds and other large investors are increasing their exposure to bonds

at the expense of equities,” says Ms Zemek “But given the choice, we are buying shorter-dated bonds and we are buying ones with inflation protection.”

Changing demographics, particularly in the developed world, also benefit bonds “The demographics of the wealthy world suggest that there will be more aging and this will require a greater shift towards age-related products, of which bonds are certainly one,” says

Ms Zemek

Changing perceptions of risk

But while banks and other investors will continue to place great emphasis on sovereign debt as an asset class, they will increasingly take the view that not all government bonds are created equal Before the crisis, there was an assumption that all sovereign debt had similar risk and that spreads between countries were minimal Investors are now more discriminating

Corporate bonds from the most creditworthy companies will yield less than their

sovereign benchmarks

The credit capacity of developed economies will diminish significantly

compared to capacity today

In the aftermath of another financial crisis, governments will not have sufficient

credit capacity for the massive intervention required to re-start the economy

Developed countries will not stop increasing their levels of indebtedness

until investors force them to by scaling back on debt purchases

Chart 5: Financial executives say that the sovereign crisis is far from over

Opinions of sovereign credit over next 3 years (agree minus disagree)

This reassessment of risk raises questions about how fixed

income products should be priced in the future “If the

government bond you own is no longer a risk-free rate, then

you have a re-orientation of the corporate bond market,”

continues Mr Abberley “Rather than saying a bond is 112

basis points over you have to go back to the days when you

say: the yield is 7% But is that the right number?”

Of course, sovereign debt is not the only asset class that is

perceived as riskier as a result of the financial crisis Asked

how their risk perceptions had changed over the past year,

more respondents said that risks were higher than lower for

every single asset class (see Chart 6) Indeed, currencies and

equities were perceived to have become even more risky than sovereign debt

At the same time, a significant minority of respondents said that certain asset classes had become less risky The top three were classic inflation hedges: real estate (both residential and commercial) and commodities And indeed,

a majority of both corporate and financial services executives said that they had begun to fear the impact of inflation more than deflation This stands in contrast to the survey that preceded this one – done in August of 2009 – in which executives split close to 50-50 on expectations for the impact of inflation versus deflation

Chart 6: Financial services respondents perceive all asset classes as becoming more risky

over the past year

Commodities Hedge funds Private equity U.S Treasuries Residential real estate in my country Sovereign debt of my country, if not U.S.

Corporate debt in my market

Equities Commercial real estate in my country