Fiscal loosening raises risk of country defaults
Tue, Feb 10 2009, 07:06 GMT
by Trevor Williams
Financial markets are becoming increasingly concerned about the loosening of fiscal policy that is now underway around the world as governments respond to the tumult in credit markets and the onset of recession. Public sector balance sheets globally are taking on some of the debt the private sector can no longer absorb. According to Bloomberg data for instance, in the period since the credit crisis first broke in 2007, financial institutions have raised $970bn in new capital; of this total, the public sector has contributed $471bn. But in addition to this, with tax revenue falling as economic growth slows and public spending rising as unemployment increases, budget deficits are getting bigger and net debt is rising as a share of gdp. This is the correct response to the crisis and will help foster economic recovery eventually, but the price is that the financial position of many countries is now deteriorating, in some cases quite sharply.
Around the world, governments are borrowing more to offset recession and deal with the credit crisis...
These two trends are illustrated in charts a and b. In chart a, of 28 countries shown, 18 are running net debt positions – in other words, they have more liabilities than financial assets. Of the 10 that are savers, i.e. in financial surplus, at least 2, Iceland and Denmark but especially the former, are likely to be in a net debt position in 2009, with liabilities outweighing assets, as the latter falls and the former rises. According to the latest IMF report, 2009 will see a 1.5% of gdp fiscal stimulus from the top 20 countries in the world. The fiscal easing in the advanced economies is even greater, approaching 7% of their combined gdp.
This is the background to the sharp shift that has occurred in credit default swaps for sovereigns in the past year, see chart c. It is a reflection of the fact that financial markets believe that the risk, or likelihood, that a country will default on its bonds has risen sharply. At the time of writing, the CDS rates on 5-year US, UK, German, French and Japanese are all many times higher than they were as recently as August 2008. The chart illustrates that a series of calamitous events in credit markets have precipitated this rise. Chief amongst them was the rescue of Fannie Mae and Freddie Mac, quickly followed by the fall of Lehman Brothers on September 15th and the rescue of Merrill Lynch and Washington Mutual. But these events were not just limited to the US; there were banking bailouts in many other countries around the world.
...this is leading to a sharp rise in CDS rates as the probability of default increases...
All sovereign CDS rates have risen, so this is a global event. But UK and US CDS rates are well above those in Japan or Germany, even though each of these latter countries have bigger outstanding debt than them. The explanation is possibly that the UK and the US may be running bigger fiscal deficits in the next five years. But it could also be reflecting uncertainty about the size of the deficits that the UK and US will end up with. Even so, the long run economic growth potential of the UK and the US is likely to be superior to that of Germany and Japan, even with some reduction in the average rate of growth in the US and UK.
...and a rise in inflation expectations given a higher debt burden
Some argue that CDS rates for sovereigns are misleading because a country that borrows in its own currency cannot default; since it can simply print more of it to meet its obligations. But printing money to retire existing debt usually leads to significantly higher inflation, so that lenders lose out in real terms. Hence, it may be that the rise in CDS rates is also reflecting this fear - that sovereign debt will be devalued in real terms by inflation. To some extent, this concern is shown by chart e, which suggests that there has been a rise in breakeven inflation rates in these economies, reflecting a higher risk of price inflation. Whatever the reason, however, the rise in CDS rates highlights the perception in financial markets that the probability of default amongst sovereign borrowers has risen. In turn, this implies that the cost of issuing debt by governments around the world is likely to rise in the years ahead. If there is one positive for the UK however, see chart d, it seems to be that its risks are still rated below the average for OECD countries.
