119767_Sovereign Debt, And the Need to Fix Public Finance

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UBS Investment ResearchEconomic Insights – By George Sovereign debt, and the need to fix public finance 1 December 2009

George Magnus, Senior Economic [email protected] Tel. +44-20-7568 3322

This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 14 UBS does and seeks to do business w ith companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Global Economic Comment

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Contents Contents 2 Sovereign debt, and the need to fix public finance 3 Public debt as it stands: gross versus net debt 5 The decay in fiscal balances 6 Getting out of debt may not be so easy this time 7 What is to be done, and how? 12 Conclusion 13


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Crisis update, 15th October 2014 Just over five years ago, the global financial crisis, triggered by the collapse of the US investment bank, Lehman Brothers, spread around the world. The consequences are still with us, not least as reflected in the continuing turbulence in government debt and other fixed income markets, which had to take on board the fusion of the costs of the crisis and the much larger costs of demographic change. It is ironic how large the losses in these markets have been, bearing in mind that many investors thought sovereign debt was a safe haven, and that governments encouraged or forced banks to increase their holdings of this asset class. In the latest twist, the newly elected German government has accentuated turbulence in the Euro Area by admitting that the integrity of the single currency is being compromised by the failure of highly indebted southern European countries to embrace structural budgetary reform, and that it is open to the idea of the creation of a new Eurozone, comprising itself, France and other smaller northern European countries.

This latest crisis follows the shockwaves, initiated by the by the downgrade in the UK’s sovereign rating following the indecisive election result in 2010. The resulting decline in Sterling and the rise in gilt yields precipitated the fall of the government, new elections, and an emergency programme of radical fiscal restructuring, accompanied by the temporary imposition of capital account controls – rather like those implemented by many major emerging markets after Brazil’s slightly botched attempt in 2009, though they were trying to keep capital out, not in. Later that year, US sovereign debt was downgraded too, and the Obama Administration had to work with the new Congress in which Republicans made significant gains, to produce a new Budget aimed at rebuilding confidence among the nation’s creditors.

Last year, the crisis of trust in fiscal sustainability spread to Japan, where public debt to GDP had risen above 300%. Rapid ageing had seen a steady decline in the national savings rate and pushed the country’s current account into deficit. The reluctance of domestic investors and institutions to refinance longer-term JGB holdings, and to step up foreign asset purchases pushed the Yen down to $150, and pushed 10 year JGB yields up to 5%.

In breaking news, we are just hearing that the German Chancellor and the French President are about to hold an emergency press conference. We will be over there shortly, but a quick word from our markets correspondent, as the Euro falls to an all time low against the US dollar and even the pound…..

Sovereign debt, and the need to fix public finance Total fantasy, of course – but not so outrageous as to be implausible. The financial and economic crisis has brought about a substantial transfer of private sector debt to the public sector, often using the banking system as a conduit in ways that Minsky Moment adherents expected, but on a scale that could not really have been imagined.


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Direct and indirect involvement of the State in the running of banks and financial markets, overt support measures for banks and other parts of the economy through discretionary fiscal measures, and the typical weakness of tax revenues associated with recession and weak growth are the main culprits. In addition, several countries, especially the UK, US and Ireland, are witnessing a structural deterioration in tax revenues, following the shocks to the financial services and housing sectors. Although an economic recovery is underway – which should help to stabilise public borrowing in the next year – continuous, let alone, significant economic growth cannot be taken for granted. The timing of the crisis could not be worse for public finance, in view of the imminence of the steep rise in age-related spending in all developed nations. It wasn’t as though we didn’t know about this before, but now, the scale of the problem has been exposed. It is small wonder then, that public debt management and policy loom large in economic and market sentiment and thinking.

Public debt, ignoring off-balance sheet and contingent liabilities, has risen significantly, and is expected to increase to over 100% GDP in OECD countries in 2010. The US and UK are likely to converge rapidly towards this aggregate number in 2010-11, several European countries have already breached this level or soon will, and Japan’s debt ratio is expected to rise to about 230%. A couple of rules of thumb, employed by economists are that a 10% rise in the ratio of debt to GDP raises long-term interest rates by 50 basis points, and that a 1% rise in the ratio of the budget deficit to GDP may increase yields by between 10-60 basis points, with larger changes occurring, for example, if the starting point for debt or borrowing is high, and possibly where the pace of ageing is faster.

With interest rates close to all-time lows, the danger is that deteriorating debt and borrowing ratios will collude with any rise in interest rates to produce a self-feeding fiscal decay. This makes the task of fiscal adjustment all the harder – and more urgent, i.e. to head off or avert the possibility of an untimely rise in long term interest rates. Consider, for example, that debt service costs in relation to GDP in the UK are expected to double, and according to the IMF, US debt service costs will exceed defence spending and health and education spending by 2014. The rise in US debt service costs alone will be twice the annual bill for environmental protection.

At this time, there is no public debt crisis, per se, although there has been some movement in sovereign spreads and CDS rates, related for example, to concerns about sovereign risk in Greece, Ireland and, most recently, Dubai. However, for the large majority of countries, government 10-year yields remain in a largely stable and concentrated range. Australia and Japan, at opposite ends of the debt to GDP scale, have the highest and the lowest yields, respectively, and most other major nations, with debt to GDP ratios between 60-120% all have comparable yield structures, notwithstanding some tendency towards widening spreads.

Further, the alarmist rant from noted analysts, bloggers and politicians earlier this year that the increase in public borrowing, QE and so on were taking us quickly to another systemic financial crisis have proven to be wide off the mark. The reality is that public borrowing is substituting for the dearth of private borrowing and the breakdown in the credit system, and as such, is not


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compromising – at least yet – the ability of governments to finance themselves and service debt at relatively stable and low interest rates.

That said, no one really believes the status quo is sustainable, or that solvency isn’t an issue over the medium-term, in particular if resurgent economic growth fails to come to the rescue. We have lived with high debt ratios for centuries in the past, but often at times of war and unrest, and in a global economic environment that was a far cry from the openness and sophistication of capital markets today. Moreover, the striking change is the speed with which public debt is rising, such that a doubling is in prospect in the case of the US and the UK between 2007 and 2011.

The significance of these developments should not be under-estimated. Historically, debt crises revolving around unsustainable fiscal maths are resolved in only three ways: fiscal restructuring, inflation, or default, or some combination. Emerging markets and developing countries offer many examples over the last 50 years, but these are not emerging market-specific characteristics. In the 1920s-1930s, the US abrogated the gold clause, which fixed payment of interest and principal in terms of gold, Germany had hyperinflation, and Britain was no slouch when it came to debt restructuring. The chances of accelerating inflation and or outright default look to be on the low side, while the window for fiscal restructuring is still open. However, persistent failure to utilise that opportunity would clearly change the probabilities to some degree.

Even if it is still too early for public authorities to go much beyond the non-repetition of fiscal stimulus undertaken in 2009, and the residual parts planned for 2010, it is already high time that governments draw up and publicise strategic plans and specific policy choices, designed to show how public borrowing will decline and public debt is to be stabilised and then reduced over the next 5-10 years, and as soon as the state of the economy suggests that the programmes might start. Sooner or later, financial markets will demand nothing less, but more importantly, the capacity of Western economies to avoid lost decades and to re-engineer themselves is dependent on sustainable public finance.

Public debt as it stands: gross versus net debt References to public debt usually emphasise gross public sector financial liabilities, but should also take account of the net position too, since the latter adjusts for assets held by public authorities. Unfortunately, the available data for net debt are not comparable, as countries have different definitions and valuation methods as they apply to types of debt, assets, pension plan accounting and so on. However, the main ratios, according to both measurements can be seen below.


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General Government Gross Liabilities (% GDP) General Government Net Liabilities (% GDP)

0

50

100

150

200

250

Austr

alia

Kore

aSw

eden

Spain

Norw

ayN'

lands

Austr

iaCa

nada

Irelan

d UKGe

rman

yFr

ance

Euro

Are

aPo

ertug

al USOE

CDBe

lgium

Gree

ce Italy

Japa

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-160-120

-80-40

04080

120

Norw

ayKo

rea

Swed

enAu

strali

Cana

daN'

lands

Irelan

dSp

ainAu

stria

Germ

anFr

ance

Euro

OECD UK

Portu

gal

USGr

eece

Belgi

um Italy

Japa

n

Source: OECD Source: OECD

Generally speaking, gross liabilities convey better information about financial obligations and the financial pressure on government, while net liabilities may be preferred when it comes to differentiating creditworthiness. An extreme example would be Norway, where the gross debt of 72% of GDP contrasts with net assets of 138% GDP, in large measure due to the assets held by the country’s sovereign wealth fund. Another is Japan, where gross debt of 230% GDP, compares with net debt of 106% GDP, as, for example, the assets in the postal system are netted off.

Although the financial crisis is clearly now inflating the gross liabilities of all countries, especially those such as the US, UK, and Ireland which have committed large sums of public money to the financial system, the rise in net indebtedness may eventually not prove to be so dramatic, once eventual asset sales and disposals are taken into account.

The decay in fiscal balances In a recent paper, the IMF calculated that the fiscal deficits of G20 countries will have deteriorated from 1% GDP in 2007 to almost 8% GDP in 2009. In 2010, it expects the deficit to have edged down to 7% GDP, and then, on the assumption of appropriate adjustment, to 3.7% GDP by 2014. For advanced economies, however, the deterioration goes from 2% GDP in 2007 to 10% in 2009, and then to 8.7% in 2010 and 5.3% in 2014. For them, the deterioration in structural primary balances, that is, cyclically adjusted and net of interest payments, between 2007-2010, is 4% GDP. The IMF also noted that 75% of all stimulus measures are temporary, but that 86% of revenue losses are liable to be permanent.

Apart form the fiscal balances shown for the major countries above, we also show the structural primary balances as a share of GDP estimated for 2010.


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Fiscal balances (% of GDP)

2007 2009 2010 2014 2010 structural primary balance

G20 -1.0 -7.9 -6.9 3.7 -3.3

G20 advanced -1.9 -9.7 -8.7 -5.3 -3.4

UK -2.6 -11.6 -13.2 -6.8 -7.8

US -2.8 -12.5 -10.0 -6.7 -3.7

Japan -2.5 10.4 -10.0 -5.7 -6.9

France -2.7 -8.3 -8.6 -5.2 -2.1

Germany -0.5 -4.2 -4.6 0.0 -0.4

Italy -2.5 -5.6 -5.6 -5.3 1.0

Source: IMF

Financial support measures have been announced by governments, amounting to over $10,000 billion. Several liquidity support operations in the US are no longer in demand, have expired or are due to do so by early 2010. These include the Money Market Investor Funding Facility, the Term Securities Lending Facility, and the Primary Dealer Credit Facility. Indeed, the IMF’s latest update on the size of announced and already financed financial support measures are rather lower than the estimates published in April. Nevertheless, they remain substantial, as show below.

Financial support measures (at August 2009, as % of 2008 PPP GDP)

Capital injections Asset purchases

and lending by Tsy Asset p'chases &

lending by Tsy Liquidity & other

c.b. Total Upfront

G20 (% GDP) 2.2 2.7 2.7 9.7 21.6 3.7

G20 advanced (% GDP) 3.4 4.1 4.1 7.6 29.4 5.7

Ditto (USD bns) 1160 1436 1436 2804 10038 1887

US 5.2 1.5 8.1 14.8 6.9

UK 3.9 13.8 19 36.7 20

Source: IMF

Getting out of debt may not be so easy this time In the past many countries have managed, with difficulty and sometimes precipitated by crisis, to shake off the problems associated with high or accelerating levels of public debt. Some of the noted examples include Canada (1985-1999), which lost its AAA sovereign rating for a while, managed a fiscal adjustment of 10.5% GDP. Fiscal adjustment here means the structural primary


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balance. Scandinavian countries (late 1980s- late 1990s) lowered theirs by over 12% GDP, and Ireland spent the 11 years from 1978-1989, lowering its balance by 20% GDP. More than 20 have cut their structural primary balances by at least 5% GDP in the last 40 years, and 10 cut by more than 10% GDP. The former include the US, UK, Switzerland, Italy and Hong Kong. So it can be done.

Countries that issue debt denominated largely in their own currency have advantages over countries that are reliant on foreign currency borrowing, and it helps to have a large pool of domestic, preferably, captive savings. The US scores well on the former but not yet on the latter. Japan has had both advantages until now. The UK has elements of the former, not the latter. Countries in the Eurozone have elements of both, but the pool of domestic savings is technically domestic, i.e. Euro Area, but in practice it is Germany (and other northern European countries). Therein hangs a tale, alluded to in the ‘crisis update’, that appeared at the beginning of this paper.

In 2009-2010, however, the prospects for similar success to the examples cited above in recent decades are questionable, for five reasons.

First, the scale and the spread of public debt problems suggest that it will not be easy for any individual country or region to batten down the hatches on domestic demand and look to net exports as a saviour. Indeed, the greater the preponderance of countries that look to embrace fiscal restraint over the next few years, the less likely that outcome becomes.

Moreover, high levels of public debt can have depressing effects on economic activity. If the debt level is high and the chances of discretionary fiscal changes are low, confidence that debt will be reduced will be low, and households and companies may deliver what we call in the trade, a Ricardian (equivalence) response. In other words, if the public anticipates that governments are unwilling or unable to get on with fiscal restructuring, they may simply anticipate a rise in the overall tax burden, and save more, offsetting the rise in the budget deficit. And to the extent this doesn’t happen or only partially, then the likelihood is that long-term rates will rise, which in turn will lower aggregate demand and increase debt-servicing costs.

Second, the economic environment no longer reflects those not always easy but quite different days in the 1980s and 1990s when our growth drivers abounded or were still being developed. The model of the last 20-30 years, based on ever-broader access to and supply of credit, consumer growth, and the maturing of the baby boomer bulge in the work force, has faltered, and we haven’t yet managed to re-boot. Consequently, while we may enjoy periods of economic growth acceleration from time to time, the likelihood is both that trend growth is a good deal lower than it was, and that underlying growth will remain anaemic. In such an environment, it will be difficult, especially for debtor countries, to lower public debt. Consider, for example, that Japan, which has been a persistent net creditor nation, had a debt ratio of 65% GDP in 1990 at the start of two lost decades, and it is now 3.5 times as large.

An anaemic economic environment mitigates against the possibility that tax revenues can rebound in the next few years. About a quarter of the 4% of GDP deterioration in the G20 advanced economies’ structural primary fiscal balance


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between 2007-2010 is attributable to tax revenue losses. This is not only because of discretionary tax cuts, but to weakening compliance, and more importantly, a narrowing of the tax base. For example, weaker imports and exports affect trade tax revenues and VAT, consumer spending shares may shift to tax-exempt or lower taxed goods and services, and in those countries that thrived on the tax revenues from financial services and housing, the loss of tax revenues may be permanent. That said, there are a few important countries where tax revenues as a share of GDP are relatively low, and so there are possibilities, assuming the political will exists, to extend the tax sphere as opposed to tax rates, that don’t exist elsewhere. The US is a prime example.

Tax revenues 2007-08 (% of GDP)

0

10

20

30

40

50

60

USIre

land

Japa

nSw

itzer

land

Austr

alia

Gree

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nada

Spain UK

OECD

Germ

any

Portu

gal

Nethe

rland

sNo

rway

Finlan

dAu

stria

Fran

ce Italy

Belgi

umSw

eden

Denm

ark

Source: OECD

Third, open capital markets and the capacity of asset prices to change instantly, sometimes in exaggerated form, mean that governments have little room for error, when it comes to policy formulation and implementation. This might be the case in particular when central banks are in the process also of trying to judge how and when to best withdraw financial and monetary policy largesse.

Fourth, interest rate levels are already at generational lows, so that the financial gains accruing from monetary easing and successful fiscal adjustment in past episodes cannot be repeated. Indeed, the risks appear to be skewed one way: successful restructuring will corroborate the existing yield structure, while anything else is likely to cause yields to rise. Moreover, the burden of public debt can be sustained only if governments can meet current interest payments without having to borrow more in Ponzi-fashion.

If debt is 100% of GDP and nominal GDP is flat, current yields imply that sustainability (stable debt to GDP ratio) would require a primary surplus of 3.5-4% GDP. Currently, only Norway has a large primary surplus, everyone else in the G20 and most countries in Europe have middle-to-large primary deficits. If central banks can continue to turn around the collapse in nominal GDP, as they seem to have done in the third quarter 2009, the burden of adjustment is


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facilitated, though not resolved. In any event, the task in the medium- to long-term is not to stabilise the debt ratio but to bring it down again.

Fifth, the public costs of age-related spending are set to soar. In the aggregate, OECD age-related spending is forecast to rise by about 7-9% GDP between 2005-2050. The table and chart below set out the key components of age-related spending for major countries, the predicted change in their GDP shares between 2005-2050, and a comparison of total age related GDP costs for a broader group of countries.

Public age-related spending increases 2005-2050 Total age-related spending increase 2005-2050 (% GDP)

Healthcare Long-term care Pensions Total

US 3.7 2.2 3.0 8.9 Japan 4.1 2.1 1.7 7.9

Eurozone 4.2 2.0 1.7 7.9

Germany 3.6 1.9 2.0 7.5

France 3.5 1.7 2.1 7.3

Italy 3.6 1.9 1.7 7.2

UK 4.3 2.2 0.6 7.1

Canada 3.4 1.7 1.8 7.0

Sweden 3.8 2.9 0.4 7.0

Australia 3.1 1.1 0.8 5.1

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Gree

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land

Norw

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lgium

Nethe

rland

Finlan

dUS

Switz

erlan

dDe

nmar

kJa

pan

Euro

zone

Germ

any

Fran

ce Italy UK

Cana

daSw

eden

Austr

alia

Source: OECD Source: OECD

Notwithstanding the relatively low 9% GDP suggested for the US, healthcare constitutes a major source of uncertainty (not only for the US). Even before we know the full impact of current US legislative proposals, the Congressional Budget Office (The Long-Term Outlook for Health Care Spending, CBO, November 2007) had estimated that the shares of Medicare and Medicaid in GDP, alone, could increase from 4% in 2007 to 12% by 2050.

The CBO’s Director’s Blog (18th November 2009) reported on a study undertaken by the CBO and the Joint Committee on Taxation that estimated the costs and revenues associated with the Patient Protection and Affordable Health Care for America Act, as proposed by Senate Majority leader, Harry Reid. Assuming the provisions of the Act were enacted in full and remained unchanged for 20 years, the report suggested that there could be a net decline in the Federal deficit of $130 billion in the period 2009-2019, as outlays rise by $356 billion, and additional revenues and other savings generate $486 billion. Medicare costs, in particular, would grow by 6% per annum for the next 20 years (2% in real terms), compared with 8% per annum over the last 20 years (4% real). However, it is far too early to consider these estimates with any confidence, partly because the eventual shape of health care reform is not clear, and not least because even these estimates are based on provisions that don’t even kick in until 2014. It is not surprising then, that the 2009-2019 estimates offer a very blurred picture of the first full 10-year impact.


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Age–related spending increases of between 7-10% GDP seem daunting enough, even if they are spread out over the next three to four decades, but the financial crisis has made them look rather petty. For several countries, financial stabilisation costs will push up public debt by that amount or much more within two to three years. Consequently, it is helpful to compare the net present value of age-related cost increases, with that of the current crisis, as shown below.

Financial stabilisation costs and age-related costs compared (% GDP)

Net present value estimate

Financial crisis stabilisation

costs

Age related spending

2005-50 Crisis Ageing Crisis as %

crisis + ageing

Australia 0.3 8.0 26.0 482 5.1

Austria 7.4

Canada 2.8 8.0 14.0 726 1.9

France 1.8 7.0 21.0 276 7.1

Germany 3.1 8.0 14.0 280 4.9

Ireland 13.9 14.0

Italy 0.9 7.0 28.0 169 14.2

Japan 1.7 7.0 28.0 158 15.1

N'lands 8.0 10.0

Norway 0.3 14.0

Korea 2.3 16.0 14.0 683 2.0

Mexico 6.0 261 2.2

Spain 3.7 14.0 35.0 652 5.1

Sweden 7.7 5.0

Turkey 12.0 204 5.6

UK 13.4 7.0 29.0 335 7.9

US 12.1 7.0 34.0 495 6.4

Source: IMF, OECD

The estimates, needless to say, are subject to high levels of uncertainty. Not even the full crisis costs can be ascertained with confidence today. However, the comparison is designed to highlight the quantum of age-related costs in relation to those of the crisis. In Italy and Japan, the costs of the crisis amount to 14-15% of the total costs of the crisis plus ageing, but for most countries, the costs of the crisis are little more than a rounding error.

The major conclusion is that it is simply not enough for governments to implement budgetary measures over the next three to five years, designed to lower public borrowing and debt in the wake of the crisis and the recession. They ‘should’ embrace extensive fiscal restructuring, incorporating structural reform to pension and healthcare eligibility, costs and revenues, as well as a broader re-boot of public spending priorities, and tax rates and coverage.


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What is to be done, and how? The IMF has stated that if countries are to reduce the ratio to debt to GDP back down to 60% by 2030, they must achieve steady increases in their structural primary balances. For the G20 advanced nations, this amounts to an 8% GDP swing, from a deficit of 3.5% GDP in 2010 to a surplus of 4.5% GDP by 2020, at which point it should remain stable. The chart below shows where different countries stand, based on their total debt to GDP ratios, and the required fiscal adjustment. The US has to achieve an improvement of nearly 9% GDP, but the UK, Ireland and Japan have even larger adjustments to make.

Public debt and required fiscal adjustment (% GDP)

G20US UK

SwedenSpain

PortugalNorway N'lands

Korea

Japan

Italy

Ireland

GreeceGermany

FranceCanada

Belgium

Australia0

50

100

150

200

250

0 2 4 6 8 10 12 14 16

Required adjustment

Gross debt

Source: IMF

These required adjustments are no more than indicative, and could be lower if economic growth turned out to be more robust, but certainly larger to the extent that it is almost certain we are under-estimating the costs to public finance from demographic change in the absence of compensating policy changes.

The adjustment to fiscal balances will get under way, simply by not renewing the fiscal stimulus programmes, but this is probably not much more than 10-15% of the required adjustment on average. There is little question that a real terms freeze on per capita public spending, outside healthcare and pensions, could generate a significant contribution that might be as much as 40% of the adjustment.

The remainder can come from a variety of sources including the abandonment of formal retirement, pushing the pensionable age up by one or two years within a decade, changes in public sector pension plan contributions and payments, changes in pension payments to all recipients, the elimination or lowering of middle class benefits, removal of tax privileges for home ownership, the elimination of antiquated and wasteful subsidies to companies, or to any that are not deemed important to the green economy, alternative energy, and technology, broadening the tax base where possible, raising the participation of older and


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female workers, and working with companies to extend flexible working practices and phased retirement.

How the burdens are allocated between public spending, subsidies and tax breaks, tax rates and the tax base is politics. At the same time, it is important that governments take the opportunity to try and enhance the economy’s capacity to create employment and growth by ensuring that sufficient funds are targeted to strategically important areas of investment and education. Inevitably, the more the allocations here, the greater the compensating adjustments have to be in current spending, non-priority investment, and in the tax system.

Conclusion The sharp rise in public borrowing and debt, resulting from the crisis and the economic cycle, has some worrying characteristics and is occurring at a most untimely moment. A perhaps significant part of the weakness in tax revenues may be structural, and some outlays may also be to the extent that weak underlying economic growth has a long-lasting effect in depressing revenues and keeping labour market and welfare spending at elevated levels. The bad timing is because the burden of age-related spending has now been even further exposed, and will affect public finances increasingly from now on with the seemingly relentless rise in life expectancy rates and old-age dependency ratios, and the labour force consequences of below replacement fertility.

At the same time, governments have to be attentive to the likely actions taken by central banks over the next one to two years, which might affect growth and interest rates, and they can hardly turn a blind eye to the legacy consequences of the crisis on the structure of the economy and the capacity for economic growth. While, it is clearly important to have confidence that public borrowing will be stabilised and then reduced over the medium- to long-term, it is also essential that governments ensure adequate funding for, or at least work with the private sector to facilitate tomorrow’s growth drivers, for example, a greener economy, employment, infrastructure, innovation, education, training and healthcare.

Stabilising sovereign debt and fixing public finance will require effective leadership, and imagination, and the failure to provide these is liable to be punished by debt and currency markets. Turbulence in one country’s financial markets might also end up being highly contagious, in view of comparable circumstances elsewhere.

Although the largest challenges are widely seen as concentrated in the UK and US, it is quite clear that sovereign debt is also a major concern in several countries in the Euro Area, including Ireland, Greece, Portugal and Spain, and in a number of Eastern European and central Asian economies. For the former group, membership of the single currency is a strength to the extent that they are insulated to some extent from financial turbulence, but also a weakness as the compulsion to undertake structural reform may be undermined.

Perhaps the biggest surprise though may be the spread of sovereign debt concerns to Japan, hitherto never considered as vulnerable. The crisis and some disappointment with the new government’s early performance have pushed the


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economy back into deflation, and a short-term export recovery aside, corroborated fears that the country’s growth capacity is still eroding. The consequences of rapid ageing will continue to lower the country’s aggregate savings flows and weaken the current account, while the refinancing of high coupon JGB’s issued in the last 10-20 years may prove to be increasingly problematic.

The valuation of government bonds, from an inflation or nominal GDP standpoint, isn’t really the issue. Rather it is that a failure on the part of any government to step up to the challenge of fixing public finance, especially given the uncertainties related to central bank exit strategies, could easily trigger adverse financing problems in local currency and bond markets, which may then spill elsewhere. A spike in long-term interest rates may not be easy to forecast, but seeking cost-effective portfolio protection against it might be worth its weight in gold, or…..whatever.

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119767_Sovereign Debt, And the Need to Fix Public Finance