ONE year after the global bank crisis, investors’ worries have shifted from bank debt to sovereign debt. Western governments’ public deficits have grown considerably in a double-whammy of bank bailouts and fiscal stimulus. Those who question the effectiveness of the various stimulus programmes need only look at the sluggish growth in the fourth quarter of 2009 in the US, UK and Eurozone. How much worse would the GDP numbers have been without government intervention?
Investors worry about this free lunch. As the Greece crisis has demonstrated, higher debt raises questions about how it can be serviced. The chart to the right shows debt variation among selected economies, and one can see how certain countries that do not command market confidence might be singled out for attention. A rise in credit risk premiums is a natural response to this worry.
Debt is an emotive subject. “Neither a borrower nor a lender be,” advised Polonius in Hamlet, but of course if everyone did that, then the world would come to a halt. For an individual or a corporate, debt becomes serious when it can’t be serviced, or rolled over on maturity, or is called in early. For a country the same principles apply, but countries have slightly more leeway because they can print more money. What is important for sovereign borrowers is creditors’ confidence in their ability to service and roll over the debt, rather than the absolute level of borrowing. So the worry about countries’ debt levels really reflects a loss of confidence.
The primary factor driving confidence is a country’s monetary and fiscal policy management. Greece surrendered control of its monetary policy when it joined the euro, and its fiscal policy is now viewed with suspicion (as are its official statistics). Once confidence goes, debt servicing becomes very difficult. Ultimately therefore, some sort of EU bailout of Greece is likely, which will shift focus onto the other troubled Eurozone countries.
The markets have focused attention on certain countries’ debt levels, reminding policymakers that they must restore confidence if they are to carry on borrowing money in the capital markets. Governments cannot ignore the absolute level of debt, otherwise borrowing costs would go so high that debt servicing would be untenable. But they do need to come up with integrated monetary and fiscal policies that reflect their problems.
The key questions from investors are: at what point should governments begin to withdraw fiscal stimulus?; and when should central banks start to raise interest rates? There are two sides to this debate. The neo-Keynesians believe that stimulus needs to be kept in place for the foreseeable future, because the global economy remains weak. This appears to be the consensus opinion among governments and multilateral agencies, who view the risks thus: if one removes stimulus too late, the problem will be a larger debt burden and a rise in inflation. Withdraw too early, however, and there is a risk of global recession, if not depression.
The opposing view is that Keynesian-style spending can only achieve a finite amount of good, and we appear to be at its limits now. The Economist magazine last week reported that there is evidence that fiscal stimulus undertaken by heavily indebted governments loses effectiveness because it dents market confidence, and consumer demand actually falls.
Of course, the markets may not wait for governments to start changing policy, as rising bond yields in the southern Eurozone demonstrate. Therefore, this issue remains on the table until markets are placated (which will happen once governments announce a credible economic strategy).
The fiscal policy debate is ongoing, but at what stage is the monetary policy cycle? Not much further advanced. Interest rates are essentially zero, so there is no room to balance any fiscal tightening with further monetary easing. However, the inflation debate becomes urgent once the recovery starts. Should interest rates then rise to meet this threat? In a word, no. Higher rates would increase debt servicing costs, which would renew pain for consumers and companies. Only once recovery is underway and is being sustained, and government stimulus has ended, would it make sense to start raising rates.
What does this mean for interest-rate markets? The prospect of a further year of near-zero growth will keep sentiment negative and the risk premium high. We would ordinarily expect the yield curve to start flattening as markets anticipate higher short-term interest rates, once central banks start withdrawing accommodative policy and start raising rates.
But for the US and UK, and possibly the European Central Bank, this is unlikely until 2011. So in anticipation of more investor nervousness, expect further curve steepening this year, and higher long-end interest rates, before any subsequent flattening once rates start rising. There are many more scare stories to come, from both sovereign and corporate borrowers, before market confidence returns.
Moorad Choudhry is Head of Treasury at Europe Arab Bank and editor of the EAB Treasury Morning Shout. www.eabplc.com