By Cameron Bagrie*
Our key aim in writing this article is to alert our readers to some of the wider economic forces at work.
We want to highlight the inherent tensions that exist within the economic system, and to encourage readers to start thinking about the implications for their own businesses.
Ultimately, it is the average rate of growth over a number of years (and volatility around that growth) that matters, as opposed to what GDP growth will be in any single year.
The repercussions of the global financial crisis will continue to be felt for years.
Therefore, we would encourage our readers to think about the macro themes we outline below within a five-year time horizon.
THEME 3: SOVEREIGN RISK
Our sovereign risk analysis – which encapsulates negative (i.e. debt) and positive attributes (i.e. flexibility) across 38 countries remains European-centric at the problem end.
France and Italy will be key to watch over the coming year.
Nations such as the USA continue to buy time (courtesy of greater economic flexibility), though we view the clock as ticking. Interest rates will need to remain low and anchored for fiscal sustainability issues to be addressed, but the critical component will be economic reform driving growth. This is the missing ingredient.
What a relief!
After months of political wrangling and overt displays of brinkmanship on both sides, US politicians announced an eleventh-hour deal, averting the so-called “fiscal cliff”. But was it really a relief; and did the “deal” have any substance?
Most serious commentators thought not, and some, including The Economist, called the deal “lousy”. Indeed, they were scathing of it, noting that the final deal raised less tax than the Republicans had offered during negotiations, and lacked some of the spending cuts President Obama was once prepared to offer.
But worst of all, The Economist said, it made the United States look like Europe, who have become masters of the can-kicking quick-fix. This is how 2013 began, and we believe this is also how 2013 will unfold: with fiscal tensions front and centre.
To be fair, a host of the fiscal “issues” have arisen from the nationalisation or socialisation of private sector problems at the root of the 2008 crisis. Absorbing debt onto government balance sheets has merely bought time.
To some degree, markets have gotten used to the fiscal environment that developed countries now find themselves in.
Bond markets have become used to eleventh-hour deals, and now trade, some would argue quite legitimately, as if there is not a proverbial ambulance at the bottom of the cliff, but rather as if some scheme will be concocted to prevent anyone going over the cliff.
Thus far, it has worked. Politicians in Europe have shown themselves to be adept at coming up with cunning plan after cunning plan, and full-blown crises have been averted (see Theme 1, the cycle of [dis]trust rolls on), even if on occasion investors were left on the edge of their seats waiting for announcements. However, behind the scenes, serious sustainability issues remain.
We first recognised that all was not well in peripheral markets in 2010 and went looking for the next potential hot-spot. Markets have been on a rollercoaster ride since then, with yields in some parts of the periphery trading well into double-digits in 2011, before normalising somewhat in the past year or so. Yet Europe’s debt pile has never been bigger, and nor has America’s.
But perhaps the biggest problem has been (and will be) the lack of growth, for it is the nominal growth rate, along with the cost of financing the debt (i.e. the bond yield) that matters insofar as debt sustainability is concerned.
Addressing solvency concerns offers a Clayton’s choice in terms of solutions.
Doing nothing makes the situation worse and eventually market forces demand a premium, taking yields higher. Necessary fiscal retrenchment to restore confidence detracts from demand which makes the debt burden worse in the near-term. Such retrenchment reduces your fiscal flexibility. This, in turn, puts more pressure on monetary policy as a stabiliser and risks undermining its independence. Society is not often receptive to reform, which is required to lift growth.
And so the debt pile keeps growing
As an example, Euro area net debt has risen from 42.7 percent of GDP in 2007 to a forecast 65.3 percent of GDP this year; over the same period, US net debt to GDP has increased from 48.0 percent to 90.1 percent of GDP. Japan’s net debt is a whopping 144 percent of GDP, though this is more than offset by private sector savings.
Regular readers will recall that we developed an indicator almost four years ago to assess sovereign debt vulnerability in an objective manner, and this research builds on earlier work. Indeed, sovereign risk has been one of our key themes at the start of each year since.
From the outset we acknowledged, and still do, that we do not have the resources of a credit rating agency. However, we do have access to plenty of data, enabling us to assess a host of countries on the basis of two broad criteria.
First, we look at “bad” or “worry” variables – things like government debt, the fiscal balance, the current account, net external debt and the unemployment rate. Including variables beyond fiscal metrics such as the current account and external position means the term “sovereign risk” really personifies the risk of the nation as a whole, as opposed to merely the government in isolation.
We also recognised that there would be offsets, and looked at things like GDP per capita, population growth, the existence of a floating exchange rate, political stability, competitiveness etc. These variables are critical as they signify a degree of flexibility within the economic system: this flexibility can buy you a lot of time to work through issues.
Another way to think about this is in simple business parlance. A business with a lot of debt may be struggling, but the coup-de-grâce is ultimately delivered when the revenue line tips over. The same applies for a nation. The metric here is GDP. The death spiral beckons when debt is rising and GDP is contracting. By comparing one set of criteria against the other, we arrived at a “net” score giving a simple metric of sovereign vulnerability.
To recap on our methodology, we collect comparable statistics across 38 countries, comprising the OECD and the major Asian economies. Where possible, we collect data from the same source for consistency. Negative unfavourable scores are added to positive favourable scores to arrive at an overall vulnerability score, with the most vulnerable countries having the lowest (generally negative) overall scores.
As we noted, the two sub-scores, and how they fare are important. Having a good favourable score doesn’t eliminate challenges but they do buy you time to work issues out. Witness the US losing its AAA status in 2011.
The scatter plot and table overleaf summarise the results. Nations are ranked according to the overall score, which is the net of the unfavourable and favourable numbers. But remember, this is a peer group comparison, so it is how you measure up to the competition that matters. Because investors have a choice as to where they invest, what matters most is a country’s overall placing on the table.
Our analysis highlights several points, many of which have been consistent in our past rankings:
- Europe continues to dominate the bottom of the table. What’s more, the bottom left or “storm warning ahead” quadrant of our scatter plot of favourable and unfavourable rankings is dominated by Europe, highlighting that the area will remain a key battleground in years to come despite conditions stabilising of late.
- Euro-heavyweights France and Italy are among the bottom seven. For a long time, the focus has been on minnows like Greece. Its problems are not trivial, but they are manageable in a global context. By contrast, France and Italy (the 5th and 8th largest economies in the world) are economic giants with €3.8 trillion of government debt between them.
- The countries that made the top seven rankings have not changed, and are dominated by Scandinavia, Switzerland, Singapore and the commodity countries (excluding New Zealand). These countries all sit in the top right or “becalmed” quadrant of our scatter plot.
- The only G7 country in the top ten is Canada. By and large, the major countries were notable for how poorly their “unfavourable” scores were, but all got a reprieving “offset” thanks to being large, rich and flexible. This put them in the top left or “choppy waters” quadrant of our scatter plot. For these countries, there are problems on the debt and economic front, but size, wealth, good governance and a floating exchange rate gives them time to work through their problems. New Zealand falls just within this quadrant too. It doesn’t have much Government debt, but earthquake-induced budget deficits, a large net external debt position, and our current account deficit let us down.
- The United States’ ranking improved, but this was thanks largely to a forecast improvement in the government deficit. The OECD forecasts improvements for most countries, as do the rating agencies. But the key is delivering on these. If they don’t, another US downgrade seems inevitable at some point. The last downgrade didn’t have much of an impact on yields (they actually fell as investors flocked to the “safe haven” of US Treasury bonds!). But it was the indirect consequence – massive diversification inflows into our bond markets – that mattered for Australia and New Zealand. These flows not only put a rocket under the NZD, but they also pushed term rates lower, which had a knock-on effect to mortgage rates and the housing market.
It is also worth noting the one thing that has changed significantly is the overall distribution of scores. Two years ago, the scores ranged from -47 percent to +41 percent. Today they range from -66 percent to +47 percent (using the same methodology). The bad are getting worse, the good are getting better.
There are three basic facets to a sovereign debt crisis from a sustainability perspective. The first is the amount of debt, the second is the interest rate payable on that debt, and the third is growth.
Because there is not much that can be done quickly to reduce debt (particularly without growth), this leaves the focus on the other two facets. At the moment, yields are low – even in the European periphery (recall that Mediterranean yields were routinely in double digits pre-euro). And even if one takes a dim view of the can-kicking responses to date, they have been effective in containing yields.
But all such cunning plans do is buy time – without proper reform, the problems will persist and slowly get worse. Markets are certainly very sanguine on sovereign credit risk in general.
In short, yields are about as depressed as they are likely to be for the majors (thanks to QE), and for the profligates (thanks to can-kicking).
Austerity and credible fiscal policy is a necessary but far from sufficient condition for debt sustainability. The key ingredient is growth. The lack of it in some profligate nations is likely to be a key focal point in 2013.
*This report was written by the ANZ New Zealand economics team which consists of chief economist Cameron Bagrie, head of global markets research David Croy, senior economists Sharon Zollner and Mark Smith, economist Steve Edwards, strategist Carrick Lucas, and rural economist Con Williams. It is used with permission. Theme 4 will follow on Monday.