As One Crisis Recedes, Another Begins?

Daily Telegraph November 26, 2009

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By Jeremy Warner, Assistant Editor Published: 8:08PM GMT 25 Nov 2009

Comments 5 | Comment on this article

The bulls point to resurgent growth in the emerging markets of Asia and Latin America, and reckon the developed world will soon be following, albeit it at a slower pace. The bears focus instead on burgeoning fiscal deficits, still shrinking private credit availability and a basic lack of demand in once buoyant deficit nations. For them, the big menace is "out of control" public debt.

Yet for the moment there is no doubt which view is triumphing. Since the nadir of the crisis in March, the price of virtually all assets has risen strongly. I say virtually all, but of course one of the biggest asset classes of the lot – government bonds – has not. Bond prices are quite a bit lower than they were last March. And therein lies a large part of the bear case.

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If all governments have done in fighting the crisis is replace private debt with public debt, then they have not addressed the underlying problem. The most that can be said is that they have smoothed and stretched out the adjustment, but they have not removed it.

What's more, governments must soon start the process of rebuilding their finances, which in turn is going to act as a brake on demand for possibly years to come. In the meantime, fiscal deficits throughout the developed world are rising to levels which even the most sanguine of observers find truly scary.

Some idea of the scale of this deterioration is given by the latest edition of Moody's sovereign debt "statistical handbook". Preliminary estimates suggest that the total stock of sovereign debt will rise by nearly a half to around $15.3 trillion by the end of next year.

Sovereign debt of such magnitude is not entirely without precedent. Britain emerged from the Second World War with debts of 240pc of GDP. IMF forecasts of around 100pc in five years' time for the UK look almost pedestrian by comparison.

But for this country at least, it's still a peacetime record by a long way. Fiscal adjustment after a major war is a relatively straightforward matter. Military spending is simply switched off and things return quite quickly to normal. But when a country has been routinely spending beyond its means, then the correction in terms of tax rises and spending cuts becomes considerably more difficult and painful.

Given these challenges, the wonder is not that bond prices have not risen in tandem with equities and other assets, but that they haven't fallen a good deal further. The UK Government alone plans a record £220bn of debt issuance this fiscal year and not much less in each of the next four.

This is a mere bagatelle against the trillions being raised across the developed world as a whole. There must surely be limits both on investors' appetite for such a mountain of public debt and on the ability of governments to service and repay it.

And yet, despite the fact that these limits are being stretched to breaking point, bond markets remain remarkably calm. How come? After the collapse of Lehman Brothers, bond yields in the US and other countries seen as safe havens fell sharply. High demand for government debt as a result of risk aversion was reinforced by liquidity injections and in some cases, including the US and UK, outright purchases of bonds by central banks.

With the return of risk appetite, investor demand for sovereign debt waned, but yields have remained substantially below pre-crisis levels. Quantitative easing, under which governments borrow with money created by the central bank, has plainly helped.

Demand is also supported by a

By Jeremy Warner, Assistant Editor Published: 8:08PM GMT 25 Nov 2009

Comments 5 | Comment on this article

Demand is also supported by a massive carry trade which allows investors to borrow at next to nothing from central bank funds and then lend it out for more further down the yield curve.

The authorities have conspired to create other artificial sources of demand too, by for instance, requiring banks to hold bigger liquidity buffers. These have to be held in so-called "risk-free assets", which means effectively government bonds. Regulatory demands for more exact liability matching has further encouraged a herd-like movement among insurers and maturing pension funds away from productive investment into government debt.

Only, of course, bonds are not risk- free. The main threat is usually from resurgent inflation, which can destroy capital more effectively than even the idiocies of miscreant bankers.

For the moment, nobody's worrying too much about inflation. The margin of spare capacity in the economy – the output gap, in the jargon – is too big. That joyous moment in which output again catches up with capacity is still regrettably many years away.

The other risk is fiscal, where again market perceptions are still remarkably tame. If bond markets do crack over the next year, this is where the trouble will start. Investors will demand more for their money even in conditions where there is outright price deflation if they see rising risk of default.

Markets remain accommodative only because they expect governments to come up with and deliver on credible plans for fiscal consolidation. Those that show signs of failing to do so – notably Greece – are already being hammered in the bond markets.

Across the board, the cost of insuring against default on sovereign debt has risen markedly. How real is this danger? In countries which are monetarising the deficit – again mainly Britain and America – risk of default is reflected more through currency weakness than yields.

Sterling depreciation means that it is now 25pc cheaper for foreign investors to buy UK gilts than it was before the crisis, all other things being equal.

For higher-risk countries in currency unions (think Greece, Italy and Spain) or with inherently strong currencies (think Japan), yields are already on the march. My own guess is that fiscal risk will be one of the big defining stories of the next year, and that this in turn will create lots of difficulties for governments. Common sense alone suggests you cannot create such an oversupply and expect markets to pay the same.

The key thing to watch out for is the rising burden of interest payments as a percentage of government revenues. Most major economies are still well below the danger point of 10pc, where without radical action debt begins to compound, but such is the accumulation of borrowing that some will be perilously close or even through it in four years' time.

On present projections, some smaller countries will also breach the 12.5pc level which credit rating agencies judge to be the point of no return. What makes the position doubly worrying is that it only requires interest rates to rise a bit to put Britain and others in just such a debt trap. The flip side of economic recovery would be government bankruptcy.

For nearly all developed economy governments, simply allowing the fiscal stimulus of the last year or two to expire will not be enough. Nor will return to growth fix the problem. Debt would still be left on an explosive course. For the time being, nobody seems to care. Yields are still tame. But, as the IMF has remarked, markets tend to react late and abruptly to changed fiscal circumstances.

Small wonder that the bears have not yet been driven back into the woods. One crisis has been averted, but the fiscal one may be only just beginning.

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Comments: 5

Excellent article. Wait until after the elections in the UK and USA. The mid terms in the USA will leave the country in limbo and this will lead to great troubles and economic conflicts. The UK is just a basket case waiting for the final curtain. In my opinion, the crux of your article is that QE cannot continue for much longer. Once this is pulled the markets will collapse, interest rates will be forced higher and the housing 'rebound' will be shown for it is which is wishful thinking. 2010 Q3 onwards is going to be start of the begining of the end. Let us hope that people are prepared for it.

You mention the decline of sterling and the comparative stability of gilts. Surely that means that those foreigners who bought gilts before the crisis have lost in the region of 25% of their money, while those owning property have lost as much as 40%. As someone who has worked on a few residents' associations, I have always noticed how casual people are about large property investments. But ...the prospects for sterling don't look too good in the future. With regard to fiscal tightening, I can't see how politicians can be expected to prepare for major retrenchments when Mervyn King is so ambiguous about things. If there was a dance for him in the current TV programme it would be the hesitation waltz. He sounds quite tough sometimes, but then indicates that, if inflation stays low, QE might continue. It is plain suicide for the Tories to appear tough when Mr King is on the fence, as indeed are some commentators, one of whom writes on Mondays. I was always waiting for some guidance from business on whether we should join the euro, but never got it.

Since last March commodities and oil have risen significantly fueled by the carry trade and quantative easing. Oil has risen from under $40 last December to circa $76 even though millions of barrels of oil sits in tankers on high seas as there is nowhere to store it and equally no demand for it. But we pay for higher oil prices at the pumps (so we have less change in our pockets). Employers faced with rising imports (because raw material prices are rising) and unable to pass the inflationary rises to customers, absorb them but slash overheads (including dismissing staff). So Joe Public pays for the rising commodity prices. In every transaction there is a winner and a loser. The winners here are the banks and hedge funds (speculators) who know that by pushing up commodities and oil through derivative trading. Joe Public is the loser, we pay for those higher costs. So those bankers and traders take home billions in bonuses and salaries, whilst we have less change in our pockets. We always lose.

buy gold while you still can !!!

Of course all governments have done is replace private debt with public debt. Its called spreading the load, all for one and one for all etc. We were never asked, they just did it in our name, saddled us with an appalling debt burden for the rest of our lives, and shouted to the roof tops about how clever they had been. The disaster still awaits us; it is just going to take rather longer to unfold, than did the banking crisis. That there is any GDP growth is entirely dependent on government money printing and borrowing on which time is already being called. It is delusional to think that the private sector will be capable of picking up the baton. The surging price of gold is saying loud and clear to anybody who will listen that the emporer has no clothes. The unthinkable,sovereign defaults, will follow in the next few years, and Brown's Britain is a primary candidate.