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.

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