It’s all in the timing, says Moorad Choudhry.

One year after the global bank crisis, investors’ worries have shifted from bank debt to sovereign debt. Western governments have added significantly to their debt burden 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 Q4 2009 in the US, UK and euro-zone. How much worse would the GDP numbers have been without the 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 (chart 1) shows debt variation amongst 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.

Chart 1: Budget deficit as % of GDP, 2009 estimate

Source: The Economist, 13 February 2010

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 always print more money. What is important for sovereign borrowers is creditors’ confidence in their ability to service and rollover the debt, rather than the absolute level of borrowing in itself. 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). As any banker knows, once confidence goes it’s pretty much over. We therefore expect some sort of EU bailout of Greece, which will then shift focus onto the other troubled euro-zone countries.

What the markets have done is focus attention on the state of debt in certain countries, and so policymakers should be aware that restoring confidence is the key to being able to carry on borrowing money in the capital markets. Of course they cannot ignore the absolute level of debt, otherwise borrowing costs would rise so high as to make further debt servicing untenable. But they do need to come up with a coherent, integrated monetary and fiscal policy that reflects the problems they now face.

The key questions for 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 Keynesians believe that stimulus needs to be kept in place for the foreseeable, 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 the risk is of global recession if not outright depression, which would be much worse.

The opposing view is that there is only a finite amount of good that Keynesian-style spending can achieve, and we appear to be at its limits now. The Economist 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 in their own time, as rising bond yields in the southern euro-zone 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 one can conclude that it is sustained, and government stimulus has ended, would it make sense to start raising interest rates.

What does this mean for interest-rate markets? The prospect of a further 12 months of sluggish, 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 the central banks start withdrawing accommodative policy and start raising rates. However for the US and UK, and possibly the European Central Bank, this is unlikely to happen until 2011. Therefore in anticipation of continued investor nervousness, expect some 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 plc in London, and author of Bank Asset and Liability Management, published by John Wiley & Sons (Asia) Pte Ltd. The author can be contacted at moorad.choudhry@eabplc.com



 

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