JANE FOLEY<br /><strong>RESEARCH DIRECTOR, FOREX.COM<br /></strong><br />NOW that the panic that followed the collapse of Lehman last September has subsided, the demands on policymakers have altered. What was needed at the height of the financial crisis was a quick and heavy-handed response to prevent the world economy sliding into depression. Now that economic data is suggesting that the pace of contraction in G7 economies probably peaked in the first quarter, focus is turning towards how policymakers can bandage the wounds to national budgets that have been caused by fiscal handouts. There is also growing uncertainty over how central banks, specifically those involved in quantitative easing, can effectively manage exit policies to prevent an inflationary cycle in the future.<br /><br />The focus on fiscal deficits was triggered by the announcement on 21 May that Standard &amp; Poor&rsquo;s (S&amp;P) was revising its UK debt outlook to negative from stable. Interestingly, the initial impact on the pound was short-lived as the market realised that the UK was not alone in having a deteriorated outlook in its national accounts. Admittedly, aside from the US, the UK is likely to see the worst budget deficit/GDP ratio within the G7 this year but projections for the debt, while bad, provide an unusual source of relief.<br /><br />Using IMF forecasts, the UK government debt/GDP ratio will rise from 51.9 per cent in 2008 to 72.7 per cent in 2010. The equivalent data for Germany sees a rise from 67.2 per cent to 86.6 per cent. In fact, by 2010, Japan, Italy, Germany, the Eurozone, France and Canada are all forecasted to have higher debt/GDP ratios than the UK. Last week, Federal Reserve governor Bernanke forecast that the US debt/GDP ratio will rise to 70 per cent in 2011 compared to 40 per cent prior to the crisis. As in the UK, the pace of the rise is very unsettling but the relatively low starting point illustrates that efforts to contain the budget deficit in recent decades has helped maintain a cap on the absolute amount of debt.<br /><br /><strong>BABY BOOMERS</strong><br />But the outlook for government debt is being made much worse by the ageing population in the vast majority of the industrialised world. Baby Boomers, born between 1945 and 1964, are now entering the retirement phase. The projected increases in pension and health costs have been a worry to governments for years and should have triggered a series of reforms aimed at reducing the burden. The introduction of pension equity plans by the Thatcher government was an early response, these being part of an initiative to encourage workers to save for their own retirements and reduce their reliance on the state. The UK has also had success in encouraging labour market flexibility: reducing the costs of hiring and firing staff should lower unemployment rates over time and thus reduce the costs to government. Japanese governments have been far less successful in introducing reform &ndash; the prolonged period of slow growth in the 1990s thwarted efforts to introduce often painful structural reform. Combined with fiscal stimulus and adverse demographics, this has led to into a whopping forecast of 227.4 per cent for the Japanese debt/GDP ratio in 2010.<br /><br /><strong>STERLING SPECIFIC</strong><br />For sure, there will be painful decisions ahead in order to bring budget deficits back in order so as to contain national debt levels, but these issues are not UK specific. Thus it is correct that sterling should not have registered a significant response to the S&amp;P warning last month. Whether or not the outlook for the deficit becomes a specific negative for sterling depends on the reactions of whatever government rises from the current political mess to take the helm going forward. On the issue of monetary policy, sterling has been more vulnerable.<br /><br />It is fair to say that the currencies of countries that have used QE have tended to suffer. The prime concern is how, when the time comes, central banks will reverse the huge monetary stimulus without creating an inflationary bubble. Since QE is untested there is no foolproof answer, but higher long-term interest rates across the board and stronger commodity prices suggests the market is starting to fear a painful legacy of inflation in the longer-run.<br /><br />Central banks will have to tread a cautious line between balancing the present reflationary needs and avoiding leaving too much stimulus in the system. The fact that the ECB has avoided QE has been euro supportive. However, as the recovery gets underway the euro may yet become unstuck since far less flexible labour markets in mainland Europe are likely to mean unemployment queues could be slower to recover next year. As long as QE doesn&rsquo;t blow up in the Fed and BoE&rsquo;s faces, the US dollar and sterling could benefit more from the recovery story.<br />