The subject of sovereign defaults is definitely the theme of du jour.
It’s the question everyone will be obsessed with in 2010 — that, and the related theme, the breakup of the Euro.
Moody’s, via FT Alphaville, has created a new kind of “misery index” that merely adds a country’s fiscal deficit with its unemployment rate.
The top of the list reads like a who’s who of the names in the news these days: Spain, Latvia, Lithuania, Ireland, Greece, the UK, Iceland and the US.
Moody’s has also come up with another gloomy set of themes:
Theme 1 Aaa countries will probably not have the luxury of waiting for the recovery to be secured before announcing credible fiscal consolidation plans.
. . . A key concern is naturally an abrupt increase in real long-term interest rates after a long period of very low yields which has enhanced public debt affordability. We will address this risk in future publications and also discuss the unlikely risk of the dollar abruptly losing its predominant reserve currency status.
However, this type of risk is not certain. After all, Japan has now lived for many years with elevated public debt, deflationary pressures and very low interest rates. Also, large economies are hoping to durably influence long-term interest rates through skilful quantitative easing (QE).
But the risk is significant enough to focus governments’ minds. ―All this would require for the risks to materialise, is the combination of a global economy that is closer to (the new) economic potential, perhaps some ex ante change in the saving-investment balance at the world level (with China and surplus savers having to purchase fewer US bonds) and/or an inflation-led panic.
Therefore, it is very likely that most governments will not have the luxury to wait until 2012 to start cleaning up public finances. 2010 will probably see the inflexion point in highly accommodative policies. In the meantime, tactical changes in debt management strategies will help. The US Treasury is trying to re-profile the maturity of its debt in order to lengthen it with the aim of reducing its vulnerability to such a possible shock.
Theme 2 The “growth versus adjustment” debate is artificial: advanced economies will need as much adjustment as necessary, and as much growth as possible.
Theme 3 For countries operating at sharply lower output levels and with reduced growth potential, the debt equation will look increasingly complicated.
Theme 4 Most governments cannot afford another financial crisis. Attempting to ring-fence balance sheets from contingent liabilities will keep policy makers busy.
To say that Aaa governments have lost altitude within the Aaa space simply means that their shock-absorption capacity – while still high enough to rule out any meaningful default risk – has been reduced.
In other words, many Aaa governments, starting with the UK and the US, cannot afford another financial crisis at current rating levels. This is another reason why the reform of the financial sector has taken on such importance.
But this is also true of lower-rated governments, and more generally reflects the explosion of the size of financial sectors over the past decade as compared to governments’ balance-sheets. The key factor in this context is support capacity.
As a result, we believe that these governments are going to try a different tactic and make the preservation of their balance sheets – and perhaps of their rating – a primary objective. This will entail, from time to time, initiatives to share the burden with bondholders. There have been some attempts at ring-fencing government balance sheets in 2009, with varying rates of success (e.g. in Iceland, Ukraine, Kazakhstan, Dubai, etc.). One could even argue that allowing Lehman Brothers to default was a way of drawing a line in the sand – although, as in many cases of ―ring-fencing, the outcome was disorderly.
We have analysed the Dubai World precedent as an early example of an ―exit strategy by governments, and have reconsidered the comprehensiveness of protective policies. As a result, our bank and corporate credit risk analysis is increasingly taking this into consideration.
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