Moody’s sees sovereign states a-suffering
By Tracy Alloway. This article originally appeared on FT.com on December 15th, 2009.
Ratings agency Moody’s takes up the sovereign subject again on Tuesday, with its 2010 outlook on sovereign risk. And the mood, as the below chart should demonstrate, is rather miserable.
In fact, Moody’s has compiled a 1970s-style ‘Misery’ index. But instead of showing inflation and unemployment rates, it shows the fiscal deficit and the unemployment rate.
On that basis, Spain, followed by Latvia, Lithuania, Ireland, Greece and the UK are the gloomiest Moody’s-rated sovereigns in the world. The US is eighth — just after Iceland.
What’s more, Moody’s has come up with some rather ominous ‘themes’ for the 2010 New Year. Among them; the idea of an extremely painful debt overhang, potential social unrest and a significant amount of “exit risk” for governments trying to withdraw their unconventional economic and low interest rate policies.
Here are the themes, with selected excerpts and highlights:
"Theme 1 Aaa countries will probably not have the luxury of waiting for the recovery to be secured before announcing credible fiscal consolidation plans.
. . . A key concern is naturally an abrupt increase in real long-term interest rates after a long period of very low yields which has enhanced public debt affordability. We will address this risk in future publications and also discuss the unlikely risk of the dollar abruptly losing its predominant reserve currency status.
However, this type of risk is not certain. After all, Japan has now lived for many years with elevated public debt, deflationary pressures and very low interest rates. Also, large economies are hoping to durably influence long-term interest rates through skilful quantitative easing (QE).
But the risk is significant enough to focus governments’ minds. ―All this would require for the risks to materialise, is the combination of a global economy that is closer to (the new) economic potential, perhaps some ex ante change in the saving-investment balance at the world level (with China and surplus savers having to purchase fewer US bonds) and/or an inflation-led panic.
Therefore, it is very likely that most governments will not have the luxury to wait until 2012 to start cleaning up public finances. 2010 will probably see the inflexion point in highly accommodative policies. In the meantime, tactical changes in debt management strategies will help. The US Treasury is trying to re-profile the maturity of its debt in order to lengthen it with the aim of reducing its vulnerability to such a possible shock."
"Theme 2 The “growth versus adjustment” debate is artificial: advanced economies will need as much adjustment as necessary, and as much growth as possible."
"Theme 3 For countries operating at sharply lower output levels and with reduced growth potential, the debt equation will look increasingly complicated."
"Theme 4 Most governments cannot afford another financial crisis. Attempting to ring-fence balance sheets from contingent liabilities will keep policy makers busy.
To say that Aaa governments have lost altitude within the Aaa space simply means that their shock-absorption capacity – while still high enough to rule out any meaningful default risk – has been reduced.
In other words, many Aaa governments, starting with the UK and the US, cannot afford another financial crisis at current rating levels. This is another reason why the reform of the financial sector has taken on such importance.
But this is also true of lower-rated governments, and more generally reflects the explosion of the size of financial sectors over the past decade as compared to governments’ balance-sheets. The key factor in this context is support capacity.
As a result, we believe that these governments are going to try a different tactic and make the preservation of their balance sheets – and perhaps of their rating – a primary objective. This will entail, from time to time, initiatives to share the burden with bondholders. There have been some attempts at ring-fencing government balance sheets in 2009, with varying rates of success (e.g. in Iceland, Ukraine, Kazakhstan, Dubai, etc.). One could even argue that allowing Lehman Brothers to default was a way of drawing a line in the sand – although, as in many cases of ―ring-fencing, the outcome was disorderly.
We have analyzed the Dubai World precedent as an early example of an ―exit strategy by governments, and have reconsidered the comprehensiveness of protective policies. As a result, our bank and corporate credit risk analysis is increasingly taking this into consideration."
Theme 5 Very large public debt and low economic vitality will prompt unprecedented questions about how governments can discharge their obligations without changing the rules of the game.
A very important long-term question is: could a combination of lower trend growth, ageing and, more generally, a relentless increase in the demand for services that are provided or intermediated by the state lead to a progressive ―suffocation under the weight of public debt? This question is often raised with reference to Japan, but Japan may simply be a precursor.
The issue is ultimately: could very rich countries default on their debt? In fact, there is no historical record of ―rich countries defaulting on their debt.
Even though this is not a pressing issue for 2010, we suspect investors will increasingly try to ―think the unthinkable. A recent Moody’s report explored some of the potential implications of a possible downgrade of a large Aaa country. More on this later.
One way of looking at this is to realize that governments are more willing to default on social obligations – such as changing the retirement age – than on financial obligations."
"Theme 6 EMU participation protects against liquidity risk but not against long-term insolvency."
"Theme 7 The dangers of a rapid and debt-fuelled income convergence process will lead to renewed emphasis on total country debt."
"Theme 8 Global sovereign risk convergence is at play, but only slowly.
Despite the sorry state of public finances in the rich G20 countries and the enviable economic health of many emerging G20 economies, we believe it is premature to announce the dawn of a New Order in terms of sovereign creditworthiness.
Even though the gap between ratings has been narrowing, it is much too early to envisage that China, let alone Russia, India or Brazil could any time soon dislodge the current large Aaa economies as anchors to the global economic and financial system.
The last few miles that need to be covered to move from A or Aa to Aaa are the most arduous . . .
"Theme 9 While the crisis has confirmed the dangers of financial globalization for emerging markets, the arsenal of policy levers has not expanded."
"Theme 10 Debt hang-hover will test social and political cohesiveness.
In those countries whose debt has increased significantly – and especially those whose debt has become unaffordable – the need to rein in deficits will test social cohesiveness. The test will be starker as growth disappoints and interest rates rise.
In several countries – including some highly advanced ones like Iceland or Ireland, but also Latvia or Hungary, as well as in some much poorer countries like Jamaica – a great sacrifice is required from the respective populations. Cohesive and/or very enduring societies like the Baltic countries, Iceland or Ireland have accepted sacrifices (salary cuts, public spending cuts, etc.) that would have seemed unimaginable a few years ago and continue to seem hardly replicable in comparable societies. Indeed, such countries have an extremely high pain threshold.
In 2010, the ongoing crisis will further test such fortitude. We are closely monitoring signs of economic rebound as well as of political and social tension as early indicators of the sustainability of fiscal efforts.
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