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| Satyajit Das: Rising fiscal insecurity | | It may yet constrain the extent and strength of the recovery being assumed by fin markets |
| Satyajit Das / Oct 03, 2009, 00:43 IST |
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Strong rallies in equity and debt markets have confirmed the recovery for the “true believers”. The Global Financial Crisis (“GFC”) is over! It is useful to remember Winston Churchill’s observation after the British expeditionary force’s escape from Dunkirk: “[Britain] must be very careful not to assign to this deliverance the attributes of a victory.” There may be confusion between “stabilisation” and “recovery”.
The “green shoots” theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system and unprecedented government intervention by way of support for the banking system, near-zero interest rates and large fiscal stimulus packages. This is true of the Indian economy.
The key issue for the economic outlook is the ability of governments to continue their fiscal largesse to maintain the momentum of recovery.
A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession, and bailout packages for banks and other “worthies” means that many countries face large and continuing budget deficits.
As recently as late August 2009, the US Congressional Budget Office released forecasts that project the 10-year deficit to reach over $7 trillion, some $2 trillion more than it had estimated as recently as March 2009. Even countries with relatively healthy “balance sheets” such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, healthcare and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total over $5 trillion of which the US alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing — around 300 per cent in the US, over 400 per cent in the UK, and around 50 per cent in the eurozone. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100 per cent.
Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27 per cent of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40 per cent of GDP) and $33 trillion (86 per cent of GDP).
As a comparison, the total amount of global investment assets under management, according to one estimate, is around $120 trillion. This provides some idea of the funding task ahead.
To date, sovereign debt issuance programmes have been successful. Long-term interest rates have risen sharply reflecting supply pressures. The US 30-year rate has increased by around 1.5 per cent per annum since the start of 2009. Maturities have also shortened, increasing the re-financing challenges ahead. Participation of central banks in the US and the UK bonds, under their quantitative easing mandates, has helped keep interest rate rises down, creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of US Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear.
In the best case the government debt issuance programmes are accommodated but squeeze out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the GFC.
There is now faith-based reliance on governments’ ability to rescue the economy. Intervention has helped stabilise economic activity and the financial system but it is improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates. Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.
Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.
Assume a country has government equal to 100 per cent of its GDP. Assuming an interest rate of 5 per cent per annum and a GDP growth rate of 4 per cent per annum, a 1 per cent budget surplus is required to maintain debt at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.
Friedrich Hayek, in his Nobel Memorial Lecture “The Pretence of Knowledge”, foresaw the problem: “The continuous injection of additional amounts of money … creates a temporary demand…draws labor and other resources into employments which can last only so long as the increase of the quantity of money continues…[and] lead to a disorganisation of all economic activity.”
The position of India is remarkably similar to that of many developed nations. At both the federal and state levels, the country continues to run substantial deficits, which need to be financed in a world where the pool of available funds is more limited than at any time in recent history. Infrastructure development is dependent on either government funding or the ability of projects to obtain financing from overseas.
Fiscal insecurity may yet constrain the extent and strength of the recovery being assumed by financial markets.
The markets’ ability to avoid consideration of many of these issues reflects Mark Twain’s observation: “Ignorance more frequently begets confidence than does knowledge.”
The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall)
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