By Julie Hammond, CFA
In a session yesterday morning at the 64th CFA Institute Annual Conference in Edinburgh, Scotland, Willem Buiter, the London-based chief economist at Citi Investment Research & Analysis, told delegates that the “unsustainability of sovereign debt levels in advanced economies will remain an important market driver in 2011 and beyond.”
Buiter, a former consultant to the European Commission, the IMF, and the World Bank, added to his sobering forecast by advising investors to “get used to a world without triple-A sovereigns.” As he noted, “even the best of the bunch are still in pretty poor fiscal shape.” Standing apart from the pack is Germany, which Buiter says is the only bona fide triple-A advanced economy left in the world. “The US has not been triple-A for some time,” he contended, and the “negative outlook” bestowed by credit rating agency Standard & Poor’s is likely to be followed by further downgrades, he predicted.
“Fiscal pain will need to be suffered, unless you like higher taxes and decreased public spending,” he said dryly. As shown in the IMF’s April Fiscal Monitor, the required fiscal adjustment needed to achieve a 60% gross general debt-to-GDP ratio by 2030 is high for the advanced economies and “explosive” for the United States if rising budget outlays for social security and Medicare (to care for an aging baby boom population) are included.
In the Eurozone, the sovereign debt crises in periphery countries is inextricably intertwined with weak banks throughout Europe, Buiter said. “The boundaries between public sector and private sector finances are becoming more and more fluid,” he added, “and assets and liabilities are migrating.”
The Citi economist noted that sovereign debt sustainability depends on the financial health of all systemically or politically significant private entities, and he contended that there are two major, integrated problems in Euro area countries: Some member countries are fundamentally insolvent and at risk for dragging down the banking sector. Other countries that are financially more stable are being brought down by insolvent banks.
The original European Union/European Central Bank plan to deal with the sovereign debt and banking crises in Europe failed in part because the insolvency problems were worse than expected and also because the financial stability facilities that were established were not big enough. Slow economic growth in the periphery countries compounded the problems — and more lately, periphery countries are feeling “fiscal adjustment fatigue.”
We had the “dance of the seven veils,” said Buiter, and “each time a veil was dropped, we saw more problems.”
Today, he said, there is a “running battle” between the ECB and core European countries, which seem to be playing a “game of chicken.” Neither the ECB nor these countries’ fiscal authorities want to take exposure to the risky debt of both sovereigns and the zombie banks in Europe. The ECB believes it should step in only as a last resort and so far has been successful at forcing countries like Ireland and Portugal to “voluntarily give their wallets at gunpoint,” said Buiter.
Unfortunately, solutions to mounting debt problems are limited due to growing political and financial pressures, according to Buiter. Political resistance to fiscal tightening or providing financial support from the EU, IMF, and ECB will grow unless creditors share the burden. Northern core European countries have rejected the idea of giving more financial support through permanent transfers. And inflating the debt away seems unlikely given the ECB’s mandate. Buiter said that what is needed is a much larger liquidity facility (€2 trillion) to permit orderly restructurings and discourage fear-induced, speculative withdrawals of funds from solvent European sovereigns and banks.
Multiple debt restructurings or “reprofiling” appear to be the most likely scenarios for the European periphery countries. “Reprofiling is like giving a ‘nose job’ to the sovereigns,” said Buiter. By lengthening maturities and reducing interest rates, the debt has only changed in appearance.
Buiter next addressed sovereign debt sustainability outside of Europe. “U.S. fiscal sustainability ‘denial’ cannot continue forever,” he said. The ability of the U.S. and Japanese sovereigns to borrow at risk-free rates, despite these countries’ unsustainable fiscal fundamentals, could likely end with a revolt of the bond market vigilantes, possibly as early as 2013, and will be followed by injections of fiscal pain. The UK has already embarked on an ambitious multi-year fiscal tightening program to handle its substantial structural deficit. The risks are whether the tightening program and the coalition government will survive.
Turning back to the Eurozone, Buiter concluded that a Euro area break-up remains very unlikely because of the high costs for all involved. The risk could rise over time, however, if there is no economic growth or there are successive rounds of bailouts that cause populist uprisings and political and market contagion. The insolvency problems in European banks and sovereigns must be addressed to assure the survival of the Euro area.
“Policy makers in the Euro area and other advanced economies have the tools to put an end to sovereign debt and banking crises, but they need to act decisively and thus far have failed to do so,” said Buiter.