Monday, January 31, 2011

Sovereign credit risk: Eurozone, Japan, US, UK

There is a lot of confusion in the financial media (aside from Martin Wolf at the FT) about sovereign credit dynamics. Below is my short precis of sovereign credit risk factors:

1. Fiscal trajectory
This involves forecasting three variables: government revenue, government expense, and nominal GDP. GR - GE = fiscal deficit. Add forecast annual deficits to outstanding debt, and measure against both revenue and GDP. (The debt to revenue ratio is the more critical.) Another useful ratio is interest/revenue.

There are some scary fiscal trajectories out there, especially Japan, Greece and Ireland, which appear to be unsustainable without massive fiscal consolidation coupled with rapid GDP growth: an unlikely scenario. The US has a bad trajectory as well.

2. Debt capacity
Debt capacity is a country’s maximum sustainable debt level in relation to GDP or government revenue. Sustainable means without “debt restructuring”. There are many factors which influence this measure, such as the depth of the domestic capital market, whether the country has a fiat (printable) currency or, much worse, a currency (e.g., the euro) which it cannot print. Also important is social cohesion, the perceived legitimacy of the government (compare Finland with Egypt), and the overall level of development. Examples of high debt capacity are the UK after WW2, and Japan today. By this measure, Ireland is in much better shape than Greece. The Irish pay taxes, have a small public sector, and don’t riot much (the riots were in the North).

3. Market access
Market access is the ability of the country to refinance in the debt markets, as well as the ability of the banking system to remain funded and liquid. Here again, it helps to have a deep capital market and a fiat currency (under a fiat currency, the banks are always liquid). In the eurozone, only Germany, France and perhaps Italy have deep domestic capital markets, but they do not have a fiat currency. Japan, with the worst debt ratios in world history, has excellent market access due to its huge domestic savings glut. It can issue bonds at amazingly low yields. The banks buy the bonds and the population funds the banks.

4. External support
Greece and Ireland have lost market access. They are being kept afloat by the ECB (which discretely buys governmnt bonds and lends to banks) and by the EFSF which acts as a lender of last resort to member states. Therefore, in these two cases, the central issue is no longer the underlying fundamentals (fiscal trajectory and debt capacity) but rather the political decision-making concerning external support.

This is why the ECB is at war with the European Commission. The ECB does not see itself as the eurozone’s bailout fund (just as the Fed has little interest in buying California bonds). But the Commission has so far refused to establish a large, credible bailout mechanism for the peripherals, because Germany doesn’t want to be the eurozone’s de facto bailout fund either.

How does the UK look in this prism? It has an unsustainable fiscal trajectory as the PM and the Chancellor will happily inform you. It appears to have more runway on debt capacity, so long as the Coalition is seen to have a credible deficit reduction plan (the plan is credible, but will the Coalition hold together?). It is extremely lucky (i.e., smart, thanks to the unsung Gordon Brown) that it did not adopt the euro. Britain can grow its money supply with complete autonomy, and can let the pound depreciate to regain competitiveness. The UK’s big problem is that it has a services economy, not an export economy, and devaluation does not really make the City of London more competitive.

Market access is good unless there is a breakdown of the Coalition, which is unlikely. Should the Coalition lose its majority due to fiscal disagreements, confidence in sterling and gilts could hit a wall, and bond yields would add a default risk premium.

Here again, the fiscal trajectory is unsustainable over the next decade (according to the Congressional Budget Office). The US is entering a potentially catastrophic demographic shift, not with a surplus, but with a very high deficit. As the boomers retire, the costs of MediCare and SocSec will create a major structural imbalance. It’s actually quite frightening, considering the difficulties of a meaningful budget compromise. Can Harry Reid and John Boehner agree on anything? (The UK has a significant constitutional advantage in that the Government always commands a majority in the House.)

US debt capacity? Quite a bit of runway left,  judging by the the Japan-like Treasury yields demanded by investors. Ditto for market access; Treasury auctions are going very smoothly, and the Fed is doing its part with $600B of QE2.

External support? That would be Asia (Japan and China), which buy Treasuries with their current account surpluses. No evidence of a problem there.

So, my judgement would be that Greece and Ireland must default, the UK is at risk unless the Government keeps its majority, and the US is also at long-term risk if the GOP and the Democrats cannot agree this year on a plan for fiscal consolidation.

Monday, January 17, 2011

The China-US summit

The People’s Bank is in a real bind. Central banks have mandates. The PBC’s dual mandates are difficult to achieve: parity with the dollar and growth without high inflation. Maintaining dollar parity requires the PBC to invest China’s enormous current account surplus in dollars (otherwise, the yuan would rise in dollar terms). The PBC requires exporters to sell their dollars to the bank in exchange for yuan.

As the PBC’s balance sheet expands, so does the money supply and thus inflationary pressures. The PBC is seeking to dampen inflation by curbing bank lending and raising interest rates. The PBC could also fight inflation by allowing the yuan to appreciate, but that it out of the question. Export growth trumps inflation. The PBC’s policies have been very successful. China’s growth and prosperity since 1979 have been remarkable.

But now the PBC and the government have two problems (besides inflation). One is that China is under increasing pressure from the G-20 to allow the yuan to rise. The other is that China is concerned that the value of it’s ~$3 trillion dollar nest egg is threatened by the US’s massive deficits and by QE2, which China believes represents a stealth devaluation.

Yesterday, President Hu made two somewhat contradictory statements (in a written Q&A with the Journal) which highlight his dilemma. First, he said the the dollar’s hegemonic status is obsolete. Then, in the same statement, he said that US monetary policy “has a major impact on global liquidity and capital flows and therefore, the liquidity of the U.S. dollar should be kept at a reasonable and stable level”.

In 2009, the PBC called for a new synthetic reserve currency regime. France has made similar statements. But there is nothing stopping the PBC or the ECB from buying SDRs or diversifying their reserve portfolios.

As I pointed out in my most recent post, I expected the PBC to buy euro-denominated government bonds, and indeed it did so last week in the Spanish and Portuguese auctions. But it is one thing to buy euros and another to stop buying dollars.

The ECB could diversify away from dollars and buy yen, won, sterling, the A$, the C$, etc. But that would be symbolic. Monetary policy on the ECB’s scale cannot be conducted with illiquid, boutique currencies. Buying yuan bonds is out of the question due to China’s exchange controls.

So the PBC and the ECB are exposed to both the US credit risk (still AAA!), and devaluation. And I don’t see that there is much to do about it, other than jawboning the Fed and the Treasury, which hasn’t worked.

President Hu’s summit with President Obama will be highly scripted, and I don’t expect anything major to come out of it.