Jak Na Dluhy v EU (Dokument v AJ)

8/6/2019 Jak Na Dluhy v EU (Dokument v AJ)

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l Global Research l

Important disclosures can be found in the Disclosures AppendixAll rights reserved. Standard Chartered Bank 2011 research.standardchartered.com

John Calverley, +1 905 534 [email protected]

Special Report | 20:45 GMT 22 July 2011

Developed-country debt crisis Four ways out

High debt ratios can be reduced in four ways: austerity, growth, inflation and/or default

The euro-area crisis is not over, with more defaults possible and even EUR exits

US debt-ceiling theatrics are risky, but we are confident that the US will adjust

Summary

High developed-country debt burdens can only be reduced via some combination of

four approaches: austerity (preferably spending cuts rather than tax increases),

economic growth, inflation (via devaluation), or default. We analyse which routes are

most likely to be taken by the major problem countries (Table 1 below).

The 21 July euro-area summit eased terms for Greece, but not enough to restore

debt sustainability. The summits endorsement of a formal Greek default, at

Germanys insistence, will keep investors nervous. A major concern is that there is

barely enough money on the table to fully cover Spain, let alone Italy, if market

contagion resurfaces.

Germany is very unlikely to accept a full fiscal union, but the current muddling

through approach may not be enough unless Spain and Italy can quickly reduce

deficits and boost economic growth. A disorderly combination of defaults and euro

(EUR) exits would be a major new shock to the world economy, although the results

might not be as serious as in 2008-09. Asian countries are relatively well insulated.

There are increasing hopes that US debt-ceiling theatrics might yield a significant

fiscal agreement, though US politics are unpredictable. We are confident that, over

time, the US will reverse the upward trend in its debt ratios, primarily through a

combination of austerity (particularly spending cuts) and economic growth. We have

similar confidence about the UK, where progress is already being made.

Japans route to fiscal sustainability is hard to discern. It has a large budget deficit

and anaemic growth and deflation, yet we view default as highly unlikely. We expect

that a combination of austerity and inflation (via devaluation) will be the answer.

Table 1: Likely importance of each route to debt reduction

Countries will probably use more than one

Austerity Growth Inflation Default

Cut spending,raise taxes

Requires reformand investment

Requiresdevaluation

Easier if lossesborne by foreigners

Greece Medium Low Very possible Certain

Ireland High High Possible Very possible

Italy High Low Possible Possible

Japan Medium Low Likely Very unlikely

Portugal Medium Low Very possible Very possible

Spain High Medium Possible Possible

UK High High Limited Very unlikely

US Medium High Limited Very unlikely

Source: Standard Chartered Research


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Debt concerns rising

Contagion threat spreads to Italy

In a report published in early May, we said, A full-blown crisis would arise if Italy has

difficulties with rolling debt or if popular pressure radically changes the German

governments approach (Special Report, 5 May 2010, Q&A on the euro-area

crisis). At the time, we envisioned these risks as a potential threat down the road.

Instead, they emerged just weeks later. Germanys insistence on private-sector

participation in helping to meet Greeces funding requirements (though perfectly

justifiable from a tax-payer point of view) opened a Pandoras box. Perhaps Greece

would have opened it anyway before long, by just saying no to further adjustment

and beginning to ask for restructuring. But now that the box is open, it will be very

difficult to close.

When the rating agencies stated that unless any restructuring was entirely voluntary

it would be treated as a selective default (SD), it looked at first as though Germany

would back down. But the German authorities seemed to conclude that if even a

small contribution from the private sector would receive a selective default (SD)

rating they might as well tackle the problem robustly. The 21 July summit formally

endorsed debt reduction for Greece, which will involve investor losses of about 21%

via debt rollovers or swaps. The rating agencies are likely to assign a SD rating, at

least for a time, and investors will worry about default spreading to other countries.

Markets have long believed that Greek debt would need restructuring at some point,

but the onset of austerity fatigue in Greece and bail-out fatigue in Germany has

come earlier than expected. With Germany forcing a restructuring on Greek creditors,

there are fears that other countries might follow. How much tolerance of austerity

fatigue do other populations have, if growth stays negative or sluggish? With

competiveness weak, this is a real risk. Restoring competitiveness via deflation

makes debt burdens worse, while achieving it via structural reforms will continue to

meet political resistance. Ireland, Portugal and Spain are the prime suspects in line

behind Greece, but Italys slow pace of adjustment, even though it has less adjusting

to do, has raised market fears.

Table 1: Euro-area debt crisis scorecard

CountryNominal GDP

(2010,EUR bn)

Rating(Weakest

rating)

Publicdebt toGDP

(2011E,%)

Budgetdeficit(2011F,% GDP)

Primarydeficit(2011F,% GDP)

Gov. debtheld

abroad(2010, %)

House-hold debtto GDP

(2009,%)

GDPgrowth

(2011F, %)

Currentaccount(2011F,

% of GDP)

BanksTier 1 ratio(H1-10,%)

House prices(since

Q1-07, %)

Germany 2 498 AAA 75.9 -2.7 -0.3 52.8 63.9 2.5 4.6 10.7 0

France 1 948 AAA 86.8 -6.3 -3.5 64.4 69.5 1.8 -3.4 10.3 5

Italy 1 548 A+ 120.2 -4.3 0.2 47.0 56.5 1.1 -2.7 8.6 3

Spain 1 051 AA 69.7 -6.4 -4.6 49.6 90.2 0.7 -3.8 9.1 -23

Netherlands 586 AAA 66.6 -3.9 -2.2 66.4 130.4 1.7 6.8 11.4 -2

Belgium 352 AA+ 100.5 -4.6 -0.5 68.3 54.5 1.8 2.0 14.1 13

Greece 232 CCC 150.2 -7.4 -0.9 61.5 62.1 -3.0 -8.0 10.2 -6

Ireland 157 Ba1 107.0 -10.3 -7.5 59.4 124.9 0.9 1.5 10.3 -38

Portugal 171 Ba2 88.8 -4.9 -1.6 56.7 107.5 -1.0 -8.0 8.2 7

Euro area 9 172 86.5 -4.6 n.a. n.a. 66.0 2.0 0.0 n.a. n.a.

Sources: Bloomberg, EU Commission,ECB, CEBS, BIS, IMF, Standard Chartered Research

Contagion to Italy has taken the

euro-area crisis to a new level


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In another report, published last year, we argued that the long-term fiscal

sustainability of Spain is better than Italys (On the Ground, 19 May 2010, Europe

Spain, Italy default risks are low). Although Spain has a larger deficit and more

problems in the private sector, with the collapse of the construction market, it alsobegins with a far lower debt ratio (70% at end-2011 versus 120% in Italy) and seems

more capable of regenerating economic growth. The markets were not seeing it the

same way then, with Spains spreads and CDS significantly higher than Italys. As

recently as mid-June, Spain was paying 4.8% on 5Y government bonds, while Italy

was paying only 4.0%, versus Germanys 2.2%. However, in the last week, Italian

and Spanish yields converged above 5%, though yields have since fallen back to

4.75% and 4.95% respectively. They are still below the 6-7% level which would be

unsustainable over the long term, but not comfortably so.

EFSF may be too small now to fully cover Spain; certainly not Italy

With more money agreed for Greece, and possibly more needed for Portugal andIreland the European Financial Stability Fund (EFSF) now has enough funds to provide

liquidity to Spain for only a year or so if market borrowing costs become too high. The

additional flexibility for the EFSF agreed at the summit means that the available money

could be used for financial support without a formal programme and also for debt

purchases, a welcome change. But the EFSF urgently needs more funds. To have

enough to cover all of Spain and Italys borrowing requirements until 2014 (new

borrowing plus rollovers) would require the EFSF to double or even triple in size.

However, since neither Italy nor Spain could contribute if contagion returns to Italy, the

burden on France and Germany would be correspondingly higher.

Muddling through may not be enoughIf markets lose confidence in Italy as well, Germany would have to choose between

accepting the burden of fiscal union or facing the turmoil of defaults and possible

EUR exits. We still feel that dropping the EUR itself is extremely unlikely it is in

Germanys interest to stay in a single currency environment that includes France and

other relatively closely integrated countries. But moving forward to fiscal union is

almost as unlikely, despite the hopes of European integration enthusiasts. The

political institutions are not yet in place to make this a safe option for Germany, let

alone a desirable one. Germany would face higher borrowing costs and its credit

rating could be at risk.

Chart 1: 5Y government yields surge

Greece leads the way

Chart 2: Euro-area periphery stock markets sag

Stock indices seen the October 2007 peak

Sources: Bloomberg, Standard Chartered Research Sources: Bloomberg, Standard Chartered Research

0

5

10

15

20

25

Jan-00 Dec-09 Mar-10 May-10 Aug-10 Oct-10 Jan-11 Mar-11 Jun-11

Greece gov't bond 5Y Italy Gov't bond 5Y

Ireland gov't bond 5Y Portuguese gov't bond 5Y

German gov't bond 5Y

0

50

100

150

Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11

S&P_US (Oct 5 '07=100)

DAX_Germany (Oct 5 '07=100)

IBEX_Spain (Oct 5 '07=100)MIB_Italy (Oct 5 '07=100)

ASE_Greece (Oct 5 '07 =100)

We still think Spains fiscal position

is better than Italys and

the market is coming around

to our way of thinking

Germany may eventually have to

choose between fiscal union

or accepting defaults,

or even exits from the EUR


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There is still a possibility that contagion will not return. If Italy and Spain could inspire

more confidence in policy and generate a real improvement in the coming months,

markets might calm down. But it is hard to be optimistic given the scale of the

problems and the difficulty of generating stronger economic growth, especially in aclimate of uncertainty. Meanwhile, the risk of a backlash from taxpayers in Germany,

the Netherlands, Finland and elsewhere remains.

Is some form of global bail-out possible? The US and UK are both very concerned

about the European crisis and it is a threat to China and the rest of the world too. So

perhaps more funds to supplement the EFSF could be put up by the IMF, the US or

even China, which might at least avoid Germanys difficult choice for now. One problem

is that the IMF is always regarded as a preferred creditor even though it is not formally

senior; the US and China might demand seniority too. This means that investors would

continue to see lending as risky and the markets would likely not re-open until countries

could substantially improve the debt outlook. The question remains: Can countriesrestore growth and reduce debt burdens, or will their lack of competitiveness together

with political pressures as austerity fatigue mounts get in the way?

Italy is the key

If the crisis returns, Italian borrowing costs may well rise to unmanageable levels,

while funding for Italian banks both foreign lines and domestic depositors will

decline. Eventually, the only way out may be either for countries to ask for a

rescheduling of debt or to re-establish their own currencies. Reverting to individual

currencies would imply a default, since governments would likely repay the debt in

their new currency, which might be worth 70% of the EUR at best, and more likely

only 30-50%. The size of the Italian economy and debt means that a default would bea huge shock to the European banking system. Spain and the other peripheral

countries would likely go the same way, adding to the problems.

A default without leaving the EUR is likely to be countries first choice as we already

see with Greece. The question is whether this will be enough to restore economic

growth in the long run, without a major improvement in competitiveness too. In

principle, weaker countries could re-establish individual currencies through a collective

effort from northern countries and the ECB to make the transition relatively smooth. It

could be accompanied by promises that the rift is only temporary and countries

will return to the shared currency (at a lower exchange rate) before too long.

Chart 3: The debt and deficit spectrum

Net debt versus underlying primary balance 2011

Chart 4: Government finances out of line

Total government outlays and total receipts 2011

Sources: OECD, Standard Chartered Research Sources: OECD, Standard Chartered Research

0

20

40

60

80

100

120

140

-10 -8 -6 -4 -2 0

Generalgovernmentnetdebt

interestpayment%

General government underlying primary balances %

UKUS

NZ

GE

JP

FR

CA

IR

IT

AU

BE

SP

GR

PU

30

35

40

45

50

55

30 35 40 45 50 55 60

Totaltaxandnon-taxreceipts%

Total outlays %

FR

GE GR

JPIR

IT

SPSW

US

UKIPA


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In practice, the likely fast pace of the unfolding collapse, together with political

differences and anger about who is to blame, may make this difficult to achieve.

Departures from the EUR would create considerable market uncertainty, withworries about how many countries might leave and even whether the EUR might

be abandoned altogether. The EUR would inevitably decline sharply against

other currencies. Markets will also be concerned if the European single market,

the centre-piece of the modern EU, is itself under threat. It would be important

therefore that, despite what would undoubtedly be a tense, chaotic process,

Germany and France held together in emphasizing that EUR exits are a step back

for European integration, not the end of the process. We fully expect that the EUR

would continue, even if it was reduced to a rump of countries centred around

Germany and France.

Impact on the rest of the worldA Greek default is a relatively minor shock in world terms. Even a Greek departure

from the EUR would not be a disaster. The problem is, and always has been,

contagion. If Spain and especially Italy face default or leave the EUR, the shock

would be huge. Just as Lehman Brothers was allowed to fail because, given the

political environment, the US government judged it was too big to save, so the same

could happen with Italy unless it can fully restore market faith. The situation remains

dangerous. We hope that any wider shock will not happen at all, or will come later,

when the world recovery is on stronger ground and financial institutions have

increased their capital.

The three main channels for transmitting the shock of default or EUR exit to othercountries are the financial sector, trade and business confidence. European countries

would be most affected, including the UK. Losses among banks and other financial

institutions might require further injections of government capital in some cases. But

financial institutions are already effectively back-stopped by their sovereigns, so

there is no problem unless people begin to doubt the strength of sovereign debt.

The potential losses do not appear to be large enough for this. European economic

growth would take a knock too, because of the initial uncertainty, though this might

be partly offset by weaker currencies versus the US dollar (USD) and Asia and

lower oil prices. Devaluation by some countries would hurt the others. Outside

Europe, the US would be affected.

The impact on business confidence should be less serious than in 2008-09 as well.

The second time around, the shock effect should be lower, while banks and central

banks will likely make sure that credit, including trade credit, are maintained. Lower

US bond yields and lower oil prices should help sentiment too. More QE in the US is

possible too. Overall, we would not expect a euro-area split (even including Italy) to

be as damaging as the Lehman crisis.

Although likely to be much less severe than the 2008-09 financial crisis, this outcome

will surely mean a new slowdown, at least for a time. Lower asset prices as risk

positions are reduced and disruption in the European economy all point this way.

The key channels are financial,trade and confidence


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Impact on emerging countries

A recession in Europe would dent emerging-country exports, especially if the US

slowed significantly too. The risks of financial problems are limited by the generally low

exposure of Asian financial institutions to European banks (just as we saw this channellimited after the US financial crisis). The confidence channel is important, however. A

fall in world stock markets and risks assets generally would have a negative effect on

Asia. It might not be all bad, since many countries are still trying to cool over-heating

economies. We continue to see Asia as relatively well-insulated, given its high

underlying growth potential, large FX reserves and strong financial systems.

US may test market tolerance

Across the Atlantic, the markets have, so far, remained relaxed about the US fiscal

negotiations. Indeed, US borrowing costs have gone down because of the euro-area

crisis. The latest press reports suggest that a substantial deficit-reduction deal is on

the table, worth about USD 3trn over the next 10 years. Moreover, it reportedlyincludes major spending cuts, and tax and process reform. But details are still

sketchy and the US political process is unpredictable.

If this deal falls through, anxiety will rise. The apparent willingness of some members

of the Republican Party to risk even a temporary default is worrisome. If it does come

to late payments, or even runs close, considerable damage would be done to the US

reputation. Also, the negotiations have focussed attention on the size of the

adjustment needed in the US. The package under discussion is large, but still may

not be enough. If it falls through, a smaller package might be agreed which would be

a disappointment to the markets, possibly triggering a rating downgrade. The next

major window for adjustment in the US is not likely until after the presidentialelections next year.

Even though the US deficit and debt are higher than the total euro-area position, the

US situation is less worrying. The euro area is only as strong as its weakest (large)

member. Italian debt is higher than US debt, Italy cannot devalue (at least while it is

part of the single-currency system) and we have more faith in the long-term ability of

the US to adjust and to grow. But the US will need to prove that it can adjust in

coming years. Its deficit is far worse than Italys, and, if this is not corrected over the

next two to four years, the debt ratios will move up to Italian levels in a few years.

The rating agencies would withdraw the AAA rating long before this happened.

Chart 5: US real borrowing costs are low

Borrowing rates less core inflation

Chart 6: US and UK devaluation helps

BIS real effective exchange rates

Sources: Bloomberg, Standard Chartered Research Sources: Bloomberg, Standard Chartered Research

-3

-2

-1

0

1

2

3

4

5

6

Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 Jul-10

10Y Treasury yield (subtract PCE core y/y)

3mth Treasury yield (subtract PCE core y/y)70

75

80

85

90

95

100

105

110

Feb-03 Feb-05 Feb-07 Feb-09 Feb-11

Italy

USJapan

UK

Emerging countries would

inevitably be hit by another

world slowdown, but

Asian countries are

relatively well-insulated


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Japan still gets away with it

Japans net government debt, estimated at 127% of GDP at end-2011, has risen from

81% in 2007, before the crisis, leaving it second only to Greece. Just how much

longer markets will be relaxed about this high level remains to be seen. Mostof government debt is held by domestic investors, which lowers the risk of a

sudden exodus. But Japans long-term debt dynamics are problematic given the

declining working population and low rate of productivity growth. Nominal interest

rates are very low, but real rates are not so low given the deflationary environment.

So far, Japan shows no sign of seriously tackling the deficit. The earthquake tragedy

has made the deficit worse in the short term.

The UK tries to adjust, but growth is weak

Meanwhile, unlike Italy and the other euro-are periphery countries, which left

adjustment until far too late; and the US and Japan, which are still putting it off; the

UK has embarked on a multi-year austerity programme before markets demanded it.Early indications are that economic growth is struggling to retain traction, despite

near-zero interest rates, an expanded Bank of England balance sheet owing to

quantitative easing last year, and an exchange rate running 20% below the level of

2003-07. But it is still very early in the process to judge results, and the economy has

been hit by higher oil and food prices this year. We are optimistic that the devaluation

will provide the basis for a successful adjustment.

The adjustment process

It is dangerous to leave adjustment until too late

Government debt has long been high in several developed countries, including

Japan, Italy and Belgium. Yet, the borrowing premium, if any, was not large enoughto add a significant extra burden. So, debt sustainability was viewed as a long-term

issue, with the focus on trends in the deficit, the growth outlook and fiscal reforms.

But the succession of euro-area periphery countries which have seen a sudden sharp

rise in borrowing costs shows what can happen if markets begin to lose faith in a

countrys willingness and ability to service debt.

Rising interest rates make the debt burden look unsustainable, so rates may rise even

higher. It is a form of reverse bubble or market crash. Investors fear that if others are

not willing to buy new or rolled-over debt, then the government could be forced to

default. In retrospect, markets may have overlooked the risks, believing that various

tail-risk probabilities, like the worst recession since WWII or a major weakening of thebanking system, could be safely ignored. Perhaps markets were overly optimistic that

governments would respond effectively. In Europe there has also been a widely held

view that, since the EUR was clearly a political project more than a logical economic

step, governments would be prepared to move forward to fiscal and even political

union, if necessary. This view is still widely held but is open to serious doubt.

Fixed exchange rates aggravate the problem

Membership in the EUR severely aggravates the problem, as do all fixed exchange-

rate systems. This was the lesson from debt crises in the past, from Latin America in

the early 1980s (starting with Chile in 1981) through Asia in 1997. Fixed exchange

rates (or quasi-fixed in some cases) exacerbate a credit boom and allow imbalancesto build up. Then, when growth slumps, there is no safety valve to restore

competitiveness and create a little inflation. A devaluation is eventually forced, but

proves disruptive because many have borrowed in foreign currency.

Once markets lose confidence,

there is a kind ofreverse bubble or market crash

Just how much longer markets

will be relaxed about Japans debt

remains to be seen


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If Greece and others in the euro area are eventually forced to abandon the EUR, it will

be very difficult for governments to service their debt in EUR; most likely it will simply

be redenominated in the new currency (an effective default to the holder). But some

financial institutions and commercial borrowers may find that they are locked intoEUR-denominated debt and so will face distress. Eventually, devaluation paves the

way for an economic recovery (provided it does not lead to an inflation/devaluation

spiral), as Asia showed in 1998-09 and Argentina in 2003 onwards, but it takes time.

Greeces first choice is to default rather than exit the EUR

When countries are using a fixedexchange-rate system and cannot adjust, they may

prefer to default and not devalue as we see with Greece. The costs of leaving the

EUR are high, especially in the short term. Governments will try to resist abandoning

the currency since they know that it will be seen as a major policy failure, and the

benefits are likely to come through only when different politicians are in place.

Investors are aware of this preference, which is why doubts about fiscal sustainability

in euro-area countries have shown up quickly in market yields. In contrast, for a

country without a fixed exchange rate that is beginning to look fiscally unsound, the

first result will be a weaker exchange rate, as we have seen in the US and UK over

recent years, encouraged by easy monetary policy. Bond yields may rise too, but the

fear is primarily inflation and devaluation rather than default, so financing costs tend

to edge rather than rocket up.

Having said that, fiscal sustainability doubts can also feed on themselves in a floating

regime. Even a 50bps extra borrowing premium makes the fiscal picture less

sustainable in the long run, by raising the interest burden and slowing economicgrowth. So far, there is no sign of this in the US, UK or Japan. A study by Carmen

Reinhart and Ken Rogoff analysing past sovereign-debt crises found that countries

with a debt ratio above 90% tended to have slower growth than countries with lower

ratios. But correlation does not prove causality. Countries with slow growth often

struggle to prevent their debt ratio from rising, as we have seen with Japan over the

last two decades. Even if causality is accepted, the study does not mean that growth

is fine up to a debt ratio of 89% of GDP and then slows. In fact, it appears that lower

debt is generally associated with higher growth and vice-versa, across a whole range

of debt levels.

Sovereign debt is critical for the banking systemWorries about government debt make life difficult for banks for four reasons, five in the

case of euro-area countries. First, banks naturally hold significant amounts of their

own sovereigns paper in their portfolios. Indeed, since the 2008 crisis, most banks

have increased their holdings of government paper, partly out of choice and partly

reflecting the increased regulatory focus on maintaining a strong liquidity position.

Second, banks are the biggest users of long-term debt, which tends to be priced off

the sovereign yield. So, long-term borrowing costs have been rising for banks in the

euro-area periphery countries, putting pressure on their balance sheets and/or being

passed on to borrowers. Non-financial companies have to pay more for issuing

securities, too, but they are not usually such big borrowers. Also, a crisis usuallyaffects their balance sheets and profit outlook less than for banks (though depending

on their borrowings and business they are affected to varying degrees as well, a

factor which tends to hurt investment and growth).

Higher sovereign yields

hit banks and by extension

weaken the economy

The short-term costs of abandoning

the EUR would be high, while

the benefits would likely arrive

only when the next

set of politicians is in place


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Third, large banks benefit from an implicit sovereign guarantee, at least to some

extent. The guarantee has been explicit in many countries since 2008, though in

theory it is slowly being withdrawn. But if doubts emerge about the fiscal

sustainability of the sovereign, then bank borrowing costs naturally rise. Bank stocks

fall too, making new equity harder to raise. Stock markets in all the euro-area

periphery countries have been falling in recent weeks, led down by banks, and are

still well below their 2007 highs, in contrast to Germany and the US. As last weeks

bank stress tests revealed, many banks in Europe (not just those that failed) are

sparsely capitalised and not well-insulated from a major recession or upset, which is

far more likely if the sovereign is in trouble.

Fourth, difficulties for banks and doubts about sovereign backing reduce interbank

funding. Banks in Greece, Ireland, Portugal and to some extent Spain have faced

difficulty in obtaining overnight or other very short-term funding from international

banks for some time. They have had to resort to borrowing from the ECB, making the

ECB itself very uncomfortable. Italy may now face the same problem, so ECB lendingthere is likely to rise very quickly.

The fifth problem, which faces euro-area banks only, is that if depositors begin to

question the commitment to remaining in the single currency, they will move money

out to banks in Germany, Switzerland, Luxembourg or other havens. Most of it will

stay in EUR, so there is no exchange-rate implication, in contrast to old-fashioned

capital flight from emerging countries. But this outflow reduces the funding available

to banks and forces them further into the arms of the ECB. Not surprisingly, most

banks are likely to respond by reducing their balance sheets, which implies less

credit and money in their economies.

The euro area no longer publishes money supply on a country basis, on the

argument that it is not meaningful in a single currency area. However, since country

banking systems are still largely separate and, in any case, outside banks are

unlikely to be actively lending into the periphery countries in the current environment,

the drop in money and credit aggregates is a drag on the economy.

Austerity, growth, inflation or default

There are four ways to reduce a sovereign-debt burden, though more than one can

be, and may need to be, used. The exact combination that countries use will vary.

And while any country, fixed exchange rate or not, can try the austerity or default

options, the inflation option is not available within the euro area and the growth route

may be more difficult.

Austerity

Austerity means raising taxes and/or cutting spending. Research is clear that fiscal

adjustments in the past have usually worked better when the balance is heavily

towards cutting spending. However, this may partly reflect the fact that countries

with fiscal crises in the past have usually already had a relatively high tax take from

GDP. Both Japan and the US have long taken only about 30-33% of GDP in total tax

revenues, much lower than in Europe or Canada, so a case could be made that

there is more room for tax increases in those countries. However both theory and

practice also suggest that higher taxes do slow a economy by reducing work

incentives. This can be mitigated by focussing on taxes on spending (VAT and duties

etc), and reducing income tax exemptions rather than raising rates. But this is often

hard to do politically. In Britain, top tax rates were raised sharply by the outgoing

Labour government and the coalition has felt unable to reduce them.

There are only four ways to reduce

sovereign debt, though most

countries will use more than one


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Where there is less agreement is on the extent to which fiscal tightening slows

economic growth in the short term via the Keynesian demand route. Keynesians,

particularly prominent in the US, argue that, just as a fiscal stimulus can be expected

to boost growth temporarily, fiscal contraction has the opposite effect. Others argue,that the so-called fiscal multiplier is small, or even negative in some countries.

Moreover, since tighter fiscal policy improves private-sector confidence, it can

therefore encourage economic growth, despite its direct effect on aggregate demand.

This latter view is widely held in the US on the political Right, but among policy

makers is more common in Europe.

In our view, the key is the balance of fiscal and monetary policy. There are plenty of

examples historically in which fiscal contraction has not brought weak growth, but this

always seems to be because monetary policy was loosened simultaneously (lower

interest rates and a lower exchange rate). In the 1930s, for example, the UK

government ignored Keynes and tightened fiscal policy aggressively. But Britainalmost simultaneously left the gold standard, which enabled it to cut interest rates

and devalue. The economy grew strongly in the following years and unemployment

steadily fell. The UK repeated this pattern in both the early 1980s and the early

1990s, as did Canada in the mid-1990s. The key is that while fiscal policy was

tightened sharply, interest rates were simultaneously lowered and currencies allowed

to depreciate, helping to boost economic growth.

However, with interest rates already very low, there is no room for further cuts.

There is also uncertainty about the effectiveness of unconventional monetary policy

such as quantitative easing (QE). In this authors view, QE works and can be an

effective offset to tightening fiscal policy. QE in Japan from 2001-05 was followed by

Japans strongest burst of growth for more than a decade and deflation eased. QE

seems also to have worked in the US and UK in 2009-11 in supporting recovery.

In all these cases, the effects worked through higher asset prices and a weaker

exchange rate, exactly as would be expected in the transmission of an easy

monetary policy. But it is impossible to be sure of the importance of QE in

generating these recoveries versus other factors such as a natural cyclical

bounce or faster growth elsewhere. We have only limited experience and this

assessment is controversial.

A key problem for countries remaining in the euro area is that there is absolutely no

possibility of independently easing monetary policy or devaluing. Indeed, as already

noted, the outflow of funding for the banking system tends to reduce both monetary

and credit aggregates and monetary policy is effectively tightened. Even low interest

rates may not be low in real terms, if tight fiscal policy brings deflation, as is possible

and may even be necessary if they are to regain lost competitiveness.

Growth

Economic growth works to lower debt ratios by increasing the denominator (i.e.,

GDP). Of course governments need to contain the numerator (debt) too by reducing

the deficit. But growth indirectly works to alleviate debt crises by creating

employment and income growth, which ensures that the population is content to keep

servicing debt. It also makes markets believe that the debt is more likely to be fullyserviced, creating a virtuous circle as interest spreads or premia come down,

improving fiscal sustainability.

Easy monetary policy

can offset tight fiscal policy

Strong growth makes

countries both more able

and more willing

to service debt


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The key to generating faster economic growth is a combination of reforms and

investment. The most important reforms are usually tariff reduction, labour market

reforms, measures to heighten product competition and privatisation. Reforms

sometimes hit investment in the short term as businesses must realign to the newrealities. More often though, over time, they generate new opportunities and new

enthusiasm. Some economists also put considerable emphasis on Keynes idea of

animal spirits, the need for business to feel optimistic and willing to take risks

on new investments.

Fiscal crises are an opportunity for reform since, in the midst of crisis, governments

and people often accept the need for radical change. Business as usual

just wont do. But exactly how it plays out in each country depends on political

developments. A new government with a strong mandate can sometimes achieve

major change. A weak government or one that is perceived as partly to blame for the

crisis may face more difficulty. Sometimes too, measures to control the fiscal deficitmay go against reform and investment for example, higher tax rates or reduced

government infrastructure investment.

Inflation

Under certain circumstances, inflation can help to improve debt ratios. But this

depends on the country having a relatively long maturity of debt and then generating

unexpected inflation. If the inflation is expected, it will already be priced into higher

bond yields. The success of this strategy also depends on the response of the central

bank. If the central bank reacts to higher inflation by quickly raising short rates, short-

term funding costs will rise, as will long-term bond yields. The government may be

able to pay off its longer term debt over time in devalued money, but its funding fornew debt will limit the gain. If the central bank is slow to raise rates, either because it

judges that inflation will not persist or because it is not independent, then the debt

ratio will come down faster.

In our view, euro-area countries could relatively quickly improve their debt ratios by

devaluing and inflating. This would come at the expense of debt holders both

domestic and foreign. Since so much debt in euro-area countries is held by

foreigners (50-70% in most of the problem countries) this option may appear

attractive to voters. On the negative side, the hit to foreigners would naturally cause

some ructions. Greece, for example, receives an estimated EUR 5bn annually in EU

grants and subsidised loans which might be at risk. Moreover, as noted above,leaving the EUR is not likely to be the first choice for politicians because the costs

are front-loaded.

The extent of the improvement in debt depends on how much a country devalues

and, indeed whether it can quickly regain control of money. The Argentine peso

(ARS) devalued initially by about 75% in 2002, before recovering slightly to about a

67% decline. Indonesia saw a similar devaluation after the Asian crisis. If Greece

followed the same trajectory, it could push its government debt down to 50% (from

150%) in a matter of months, though it might also need to inject more capital into the

banking system.

For the US, inflation is a much less sure route to improved debt ratios. Currently,

interest rates are extremely low, with 10Y UST yields under 3% and bill rates at

nearly zero. But the average maturity of debt is relatively short at about five years.

So unless inflation rises rapidly and significantly, it is hard to make a dent in the

Arranging for inflation to erode debt

burdens is harder than sometimes

supposed, though it would work for

EUR members if they exited


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debt ratio. An IMF study found that five years of inflation at 6% p.a. versus an

expected 2% rate would cut the US debt to GDP ratio by only about 9ppt at the end

of the period (IMF, February 2010 Strategies for Fiscal Consolidation in the Post-

Crisis World). In fact, creating a sudden burst of inflation of this magnitude would bequite difficult. It is much easier to imagine a degree of inflation creep; for example,

inching up to 3% and then perhaps 4% over several years, rather than a sudden

leap. But this would have only a small effect in reducing debt.

Default

Default is usually not so much a strategy as a last resort. As already noted, if

foreigners take much of the hit, the domestic political and economic costs are lower,

though there may be other implications. One of the major problems with default is

that it usually prevents new borrowing, at least for a while. For countries which still

have a net borrowing requirement (like Greece now) this forces a rapid adjustment

and may add to the pain. It is partly for this reason that we expected Greece to avoidany hint of default until 2013-14, by which time it should have reduced its borrowing

requirement. Indeed, this seems to have been the strategy at least until recently, but

Germany insisted on forcing a default. Fortunately for Greece, new finance is

still being provided.

The long-term results of default also depend very much on policy after this. If the

country still follows poor policies, including undisciplined fiscal policy, lack of

structural reform and poor monetary policy, then the economy may still struggle to do

well and the international credit markets may stay closed. If, in contrast, the country

follows a textbook adjustment programme it will likely quickly achieve strong

economic growth and renewed access to the markets. Of course, since it is thefailure to follow a sound adjustment policy in the first place that leads to default, such

an outcome is unusual.

Country by country outlook

Greece Default and very possibly inflation via EUR exit

Greece is now certain to default, but the debt reduction agreed at the 21 July

summit is still not enough to restore debt sustainability. It might reduce the debt-to-

GDP ratio from about 170% at its projected peak next year to 130% at best.

Further haircuts are likely to be necessary (including losses for northern taxpayers

and the ECB) with an eventual total loss unlikely to be less than 50% of original

face value. This is already priced into the markets. There is also a significant

possibility that eventually Greece will leave the EUR and improve its debt ratio

via the inflation route. We do not see economic growth as providing much of

a solution for Greeces indebtedness unless Greece leaves the EUR. Greeces lack

of competitiveness as well as the stress of deflation will make investment hard to

come by. Austerity, however, will have to play a continuing role; Greece still has a

significant net borrowing requirement.

Ireland Austerity and growth could work, given time

We have much more faith that Ireland has the wealth and political strength to

successfully implement austerity measures, and the economic flexibility to regain good

economic growth in due course. However there is still a significant risk of default on

some of the debt assumed from banks. If Greece alone eventually leaves the EUR,

Ireland is unlikely to be forced to follow. However, if several countries end up leaving

the EUR, it might be difficult for Ireland to avoid the same fate (though not impossible).

The choice for Greece is between

default inside the euro area or

leaving the EUR and repaying in

its replacement currency

Default is not an attractive option

for countries that still have

a net new borrowing requirement


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GR11MY | 22 July 2011 13

Time is a critical factor for Ireland. If any further contagion to Mediterranean countries

can be delayed to 2013 or later, Ireland may be able to move out of intensive care

by then, avoiding both a chaotic default and EUR exit.

Italy Low deficit means austerity might be enough

We give Italy a high chance of using austerity to control its debt. This is not because

we are especially positive about the political process there. Indeed, we are not. But

the austerity requirement for Italy is actually quite modest, far less than for Greece or

Ireland for example, and Italy is a rich country. Italys budget deficit is estimated at

3.9% of GDP this year, before the latest measures, compared with 7.5% for Greece

and 10.1% for Ireland. Now that contagion has spread to Italy, we see a good chance

that Italians will rouse themselves and deal with the problem. The budget measures

passed last week are a good start. But more measures will be essential in coming

months if contagion is to be contained enough to allow Italian borrowing costs to

subside to more comfortable levels.

We are not optimistic, however, that Italy will be able to generate significant

economic growth to escape its debt problems; this could still undermine the

adjustment in the long run. Economic growth has been lacklustre throughout the last

decade (GDP growth averaged only 1.2% from 2003-07), despite low borrowing

costs and a favourable world environment. Also, we anticipate that while the political

will may be there to push through austerity measures, structural adjustment

measures will be harder to achieve.

Two weeks ago we would have given only a small probability to the likelihood of an

Italian default or devaluation. But, with Germanys reluctance to move ahead ofevents demonstrated once again, we fear that the situation could easily spin out

of control. It is true that Italy has a relatively long debt maturity profile, which

potentially allows time for rescue arrangements to be agreed. Even so, Italys size

probably means that it is too big for Germany to save. It is down to the Italians to

solve the problem.

Japan The outlook is murky

At present, there seems no obvious way that Japan will escape from an inexorably

increasing debt burden. Yet, while it may not have reached its limits, given the

predominantly domestic sources of financing, the steady rise in debt cannot go on

forever. An early attempt to impose austerity in 1997, via raising consumption taxes,is widely thought to have choked off growth at that time, though the Asian crisis was

also a factor. Still, a new rise in consumption taxes is on the agenda and we do see

this as part of the debt-improvement process. Japans overall tax burden is modest

compared with other developed countries.

The prospect of growth playing much of a role seems bleak. The labour force is

declining and productivity growth is low, despite still relatively high investment. Major

structural change (such as freeing up the service and retail sectors) still seems hard

to achieve. Readers may be surprised that we ascribe a medium likelihood to

inflation as part of the solution, despite Japan currently suffering from deflation. We

think that Japan will eventually suffer a crisis of confidence in economic managementwhich will take the form of an exchange-rate decline, perhaps coupled with a political

crisis. We see the outcome as a much more expansionary monetary policy. With the

average debt yield so low currently, a period of inflation of 4-5% could play a


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GR11MY | 22 July 2011 15

an increase in taxation will also be required over the medium run, with the US

tax share in GDP one of the lowest in the OECD area and, over recent years, 2-3ppt

below 1990s levels. But Republicans are adamantly against tax increases and

Democrats are anxious to defend spending. Last years mid-term congressionalelections sent a strong message that people want the budget fixed, but the politics

appear unusually polarised.

We are hopeful of a large package being agreed over the next week or two. If not, the

next chance for a full assault on the problem will likely come in 2013 after the

presidential elections. Either Barack Obama will be re-elected and, as a second-term

president, have an incentive to fix the problem to secure his place in the history books,

or, a Republican will be elected and will likely pursue fiscal virtue forcefully (though the

recent run of Republican presidents have not been particularly good at this). The US is

very conscious of its declining relative status in the world and most Americans make

a direct connection between the need to solve the budget problem and nationalstrength and pride.

We are optimistic that the adjustment in the US will also benefit from strong growth

over time. Near-term, we still see the aftermath of the housing bubble as holding

growth back, but this should dissipate over time. Then we expect the superior

dynamism of the US economy to once again shine through, supported by relatively

good demographic prospects from immigration (in comparison to Europe and Japan).

As already noted, inflation is unlikely to play a significant role in controlling debt. The

Feds five-year forward breakeven inflation rate (calculated from the TIPs yield curve)

currently forecasts inflation of about 3% in five years time. This is higher than today

and above the Feds informal 2% target, and could be about right. But it will not help

much with reducing the debt burden.


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Special Report

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