CAN THE UNITED STATES AND BRITAIN ENTER A
SOVEREIGN DEBT CRISIS?

Economic disequilibria only turn into crisis when confidence (in the willingness or ability to address the perceived problems) falters.

In the aftermath of the Great Recession most countries have registered a dramatic increase in fiscal imbalances.
Dubai surprised world markets in November and Greece from January has added dimension to sovereign debt risks. The root of the problem of sovereign risk is however embedded in the dramatic increase in fiscal deficits in most develop economies while their economies struggle to recover from the deepest recession in post-war history.

The European issue

On the European scene financial institutions have, over the last 10 years, steadily accumulated sovereign paper from Eurozone peripheral markets offering moderate praemia over Bunds. Given that peripheral markets where an integral part of the Euro area that risk seemed conspicuously negligible. During such period not much thought was given to the steady loss of competitiveness of the Southern countries that integrated the Euro zone and were showing increasing balance of payments deficits in their European trade.
In recent months, as the sheer dimension of the Greek financial debacle was revealed, German, French and some Swiss banks turned heavy sellers of Greek debt in a context where demand had literally evaporated.
These actions, not “speculators”, have been the main cause of dramatically wider spreads befalling Greek and other complacent countries sovereign paper.

From January to the end of April, European governments have displayed their disheartening inability to rapidly set and implement a containment solution to the Greek problem, let alone a strategy to prevent the future occurrence of similar situations. Political posturing has allowed the problem to fester while confidence evaporated. Now, as market pressure forces a solution, the haggling has shown how delay in mastering a serious but manageable problem can rapidly multiply the risks and the cost of a credible solution.

Sovereign risk can contaminate counterparty risk

While Greece is a small country with a large debt, the interlinking of global financial markets can, when a critical issue goes unheeded for too long, fast spread trouble throughout the system.

Only a couple of years ago, failure to master the Lehman problem has, in a space of weeks, shut down global credit markets as counterparty risk literally froze interbank lending and precipitated a global financial and economic crisis of unsuspected proportions.
Letting Lehman fail has proved the costliest policy mistake in post war financial history, turning a 30 billion denied bailout into a multi-trillion crisis and the severest recession since the 1930’s.

Similarly, failure to contain a risk of default or rescheduling of Greek sovereign debt could easily replicate the problem in Portugal and eventually beyond. Financial institutions holding significant amounts of Greek paper can rapidly be perceived as a substantial counterparty risk and lead to similar results to those seen in the Lehman debacle.

The US and UK

While Greece is relatively peripheral in world markets (with only 2.5% of Eurozone GDP), the real threat would come from a development that could seriously shake the foundations of that haven of safety that we have grown accustomed to find in sovereign paper from large developed countries.

The purpose of this paper is not to predict a crisis to sovereign debt issued by the British Treasury or the United States (it can and may well be averted). It seems nevertheless important to outline perceived risks and some of the circumstances that could dangerously transform the present situation of sharply increased fiscal deficits into a hitherto almost unthinkable crisis that might rock the foundations of the largest financial markets.

The United States and Britain are currently running a fiscal deficit of close to 12% of GDP and the ratio of sovereign debt to national income will have risen by a massive 20% in just two years.

Declining quality of Sovereign risk

In the five years that follow the onset of the crisis in 2008 the ratio of debt to GDP in Britain and the United States will have jumped from just over 60% to more than 90%.

In order to mitigate the impact of the yawning public sector deficits and maintain capital market interest rates at low levels, both the Federal Reserve and the Bank of England have entered previously unthinkable programs aimed at monetizing sovereign debt on a large scale. Printing massive amounts of money has avoided an even larger disruption of economic and financial systems, but the balance sheets of the Bank of England and the Federal Reserve have been swollen by a factor of 250% in just 2 years and widespread monetary debasement has only been avoided by the collapse in the credit multiplier observed since the inception of the Great Recession from the second half of 2007.

Given the still incipient and potentially precarious stage of the recovery, neither the United States, nor Britain have yet seen it fit to offer a clear strategy to bring their public sector deficits to sustainable levels over the medium term. The general assumption upon which rests the hope of reining in the deficits is that the economic recovery starting in 2010 will automatically generate a recovery of tax income and reduce the pressure upon spending.

The power of cyclical stabilizers can and should not be underestimated and indeed a sustained economic recovery - favouring a gradual but significant reduction in the primary deficits of the public sector - will contribute to mitigate the deterioration of the quality of sovereign debt.

The risk is that an “acceptable” deterioration in the quality of sovereign debt is critically dependent upon a sustained and vigourous recovery in the economy.

We believe that this may well be the case and certainly are not very tempted to subscribe to the idea of a ‘double dip’ recession, but this is not the purpose of this paper and that discussion would have to be argued at another time.

The issue is what would happen if, against better considerations, growth fails the test of sustainability or proves too weak or too slow to emerge?

The pregnancy of these risks leads to think that a strategy of “normalisation” in financial markets, by withdrawing the excess liquidity printed in 2008-2009, will have to be very careful and gradual and above all conditional to the vigour and spread of the economic recovery.

Another conclusion is inescapable: the massive increase in sovereign debt in developed economies leads to a substantial increase in the “structural” deficit, which is basically defined by the cost of debt servicing. This structural deficit will require a primary (cyclical) debt surplus if debt totals are one day to be reduced in absolute terms. This is admittedly unrealistic, but the growing burden of debt servicing does require at least a balancing of the primary deficit in the medium term. In other words, economic growth in nominal terms (i.e. including inflation) will have to outstrip the fiscal deficit as a percentage of nominal GDP in order to reduce the ratio of sovereign debt to national income.

Two strategies

In this context, Governments have basically two strategies available to master the sovereign debt problem in the medium term:

-The growth strategy, whereby economic expansion would be such as to generate a cyclical improvement in the fiscal deficits that would be sufficient to reduce the debt/GDP ratio. This implies that central banks will need to maintain interest rates as low as possible for as long as possible to allow economic growth to gain and sustain momentum. The strategy to be followed to prevent economic overheating and potential price bubbles in asset markets will need to see a shift from traditional tools to manage the cost of money (repos, fed funds…) to quantitative control tools in credit, managed by the modification of bank credit reserve requirements and core capital ratios for financial institutions. This policy would have to be designed to manage credit availability with a lesser impact on the cost of money.

-The rampant inflation strategy whereby a –hopefully- controlled debasement of fiduciary assets would gradually erode their value in terms of real purchasing power. This strategy has two major pitfalls: first, by defrauding the legitimate expectation of the holders of debt securities to preserve the value of their capital it would induce sales of these instruments to an extent that would raise interest rates to levels sufficient to compensate from monetary “erosion”. This backlash would however also raise the cost of servicing and refinancing sovereign debt instruments in the capital markets and be therefore self-defeating. Private bond markets would need to resort more to convertible issues to help covering the rise in long term interest rates but sovereign paper would only have the costly solution of indexing debt, an expensive expedient in inflationary times. Second: the other risk of this strategy would be the unhinging of price expectations leading to a potentially uncontrolled inflationary spiral. A risky strategy to follow if there is one.

Mastering the European problem rapidly

In the meantime markets continue to reflect the rapidly evolving perception of the issues and evaluate the credibility or effectiveness of policy responses, or lack thereof.

Mastering the European sovereign debt problem by a combination of sustained fiscal austerity in complacent countries and conditional liquidity provided by stronger partners and the IMF is the essence to avoid a crisis that could not only contaminate other countries but easily morph into a potentially explosive dimension if counterparty risk exceeds acceptable levels and drives systemically important financial institutions holding Greek paper to the wall.

The still localized perimeter of the sovereign debt crisis could explode to a global level if a convincing solution to guarantee liquidity and avoid default was not immediately found by Greece, the EU and the IMF.
The aim is not only to ensure the refinancing needs of Greece for its next deadline on May 19th, but to offer sufficient funds for its medium term needs (120 billion euros over 3 years?) against a binding and verified commitment from Greece to reduce its deficit by 8 percentage points over 2 years.

The unbearable cost of failure

Failure to rapidly move ahead of the curve on the Greek issue would drive the whole process towards uncontrolled proportions and almost inevitably threaten the European banking system with unacceptable counterparty risk that might force Governments to either bail out their national banking systems, or guarantee the debt of the affected countries.

Beyond the Eurozone, Britain and the United States, already registering fiscal deficits far superior to those of the Eurozone, could be affected in three ways:

- a failure to deliver a solution to the Greek problem that can be “bought” by the markets, would rapidly morph into an issue of counterparty risk that through the linkages in the international financial system would fast escalate to global proportions that could be reminiscent to the worst days of 2008.

- a failure to develop and sustain a vigourous recovery that would meaningfully reduce the fiscal deficit over the medium term would hardly mitigate the deterioration of the quality of sovereign debt and

- a failure to show the necessary political ability to establish and implement a detailed and credible program of containment of public spending would fail to address the issue of the cost of servicing a much expanded debt burden.

The rating agencies have already warned about the possible downgrading of the sovereign debt of the United States and Britain.

Japan whose massive debt burden, in excess of 140% of GDP is complicated by slight deflation is nevertheless a special case. Japanese Government bonds are almost exclusively held by residents and the country’s high savings rate helps to place the uncertain threshold of sustainable debt at a high level. The Bank of Japan has so far avoided massive monetisation of sovereign debt and deflation has at least helped the task of keeping nominal yields on Japanese Government Bonds at low levels.

Britain, with a much lower rate of savings and a still clouded outlook for a broadly based economic recovery could be more vulnerable if the recent surge in inflation proves anything but fleeting in a country that could be stricken by an inconclusive outcome of the imminent elections. Without a clear elected majority, a suitable medium term program to contain public spending and the deficit would be potentially compromised with parties likely to sell agreement at a high price. This can easily lead to a lengthy period of political negotiations and a potentially weak agreement when a solution would need to be found at the lowest common political denominator.
To be sure, even a political majority would have to deliver a credible solution and at this stage this can only be seen as an assumption that is unlikely to dispel the risk of serious exposure.

In the United States where the economic recovery is vigourous, President Obama does not have a majority in both houses of Congress and nothing at this stage allows the idea that one could be forthcoming in the mid-term elections in November. Up to this stage, the present Administration has been clearly more focused in pushing through its programs for the reform of Social Security and Financial Regulation.

In the minds of investors Britain and the United States are not Greece. Their debt ratios while rising at a similar pace of that of Greece and slated to exceed 90% of GDP at the horizon of 2013 are still significantly below the level of 115% presently already reached in Athens.

Greece has been pushed by a combination of market and European/IMF pressure to adopt a stringent program of fiscal consolidation but such a prospect is nowhere in sight in either the UK or the US at this stage.

A subsidiary issue should be considered if benign neglect would lead to loss of confidence, or an abrupt normalization of monetary policy that would induce a significant increase in the cost of British or American sovereign debt.

Apart from the British not many people are holding significant amounts of Sterling sovereign debt but half of the US Treasury’s notes and bonds are held outside of the United States.

Large current account surplus countries have been, over the years, piling up on American Treasury paper, making it the world’s largest asset class for reserves.

China, Japan and the Gulf countries have the core of their vast reserves in US Treasury securities. How can these countries react to the perceived deterioration in the quality of American sovereign debt? As such they would be damaging themselves by dumping American debt in any sizeable amounts. If self interest has any meaning, a large scale dumping of American debt will not happen and yet these large reserve countries cannot unconditionally be counted upon to bail out the United States under any and all circumstances. China and Saudi Arabia have already voiced concern about the preservation of their wealth invested in US securities.

To be sure, given the sheer size of the stock of reserves, one can hardly see an alternative capable of absorbing an active flow of diversification. Euro denominated securities- the next largest but still considerably smaller market- is these days fractured by significant spreads across the Eurozone.
German bunds retain the confidence of markets but given the size of its market, it cannot possibly be seen as sufficient to absorb the flow of funds that would be migrating from the vast US Treasury securities market.

Yet the risk is not massive diversification but the impact of even measured diversification away from dollar sovereign paper.

Should the perception of a deterioration of the quality of US Treasury securities take hold it would mean that the single largest instrument of international reserves, the safe haven core in times of uncertainty could have its status questioned with consequences for dollar long term interest rates and the dollar.

The risk of debasement of Treasuries is not at this stage seen as critical, or perhaps even perceived as material, but this perception can change if the Eurozone manages to control its current Greek afflictions and avoid a critical contamination into other complacent member countries.

At the present moment, market attention is focused upon the European issues affecting the Euro and is not questioning the assumption of a sustained recovery in the United States.

With solid and sustained economic growth and prudential consolidation of public spending the US can probably avoid a sovereign debt crisis but it will be considerably more difficult to escape a perceptible deterioration of the quality of its debt securities with its attendant inducement of a gradual diversification of reserve assets away from the dollar in coming years.

Should Europe manage to master its sovereign debt problems in the next few months and the European economic recovery prove –as we expect- stronger than currently assumed, then market perceptions can evolve rapidly with clear negative consequences for the dollar.