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Debt Gone Wild

Last week’s sharp drops and heightened volatility were due in part to the severe debt crisis in Greece and, more specifically, growing fears that other European nations are at risk — especially Spain, Portugal, Italy and Ireland.

Debt gone wild is a problem all over the world — much more so in the developed markets — because so many nations pumped huge amounts of money to prop up their economies as the world stood on the edge of a global depression. That devastating scenario has been avoided, but now come the longer-term effects of unprecedented stimuli.

Much of the talk has centered on Europe, which is particularly hard hit in part because economic growth has been slower returning there. According to Moody’s Economy, Greece’s debt is 115% of the country’s economic output. By comparison, U.S. total debt is about 90% of GDP. Current forecasts peg this year’s budget deficit at about $1.5 trillion.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

No one I’ve talked to sees U.S. debt escalating to levels as high as Greece’s, but one investor I spoke with off the record — a leading investor in China shared with me important information about one possible consequence that could have a major impact on the economy here.

This investor is very concerned about U.S. debt because he said 50% of China’s wealth is invested in this debt. If U.S. debt does not improve, he told me that China would scale back its buying of debt. We have seen indications of this in recent months, and further cutbacks could be critical. The U.S. would probably have to raise interest rates to make the debt more attractive to investors, and that would likely have ripple effects on interest rates domestically, affecting everything from bonds to the housing market.

A Surprising ‘Safe Haven’

What really surprised me, however, was when he revealed that one place China is considering as an alternative to investing in U.S. debt is Canada. He views Canada as more of a safe haven for investment because taxes are not likely to increase significantly and the banks there are in excellent shape — well capitalized with minimal leverage.

Canadian banks have for some time been considered among the best in the world, and they were not as affected by the financial crisis as their counterparts in the U.S. and in many other places around the world. In fact, some Canadian banks have exploited their strength recently by acquiring smaller U.S. banks that were in trouble. The expectation is this will continue as the banks there attempt to increase their presence in the U.S.

I will continue to talk with my sources and watch the situation closely here and in Investor Brief. If China were to scale back its purchases of U.S. debt, it would be a very important story with a significant impact on the economy and stocks in the second half of the year.

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