Friday, 26 June 2009

Ballooning government debt

UniCredit Group

  • Stabilization. Even though the "green shoot" euphoria has been replaced by a greater sense of reality recently, the worst is nonetheless behind us, and the global economy should stabilize in the second half of the year – thanks primarily to the billions in economic stimuli programs.

  • Debt. The flip side of this is ballooning government borrowing. The US budget deficit will probably rise to 13% of GDP this year and also remain in double digits in 2010. The dimensions may be smaller in the eurozone, but here too deficit ratios of 5% and more are unavoidable. In addition, the prospects of a pronounced improvement here any time soon are lower (pages 3-6, 7-10 & 11-12).

  • Risks. Even in case of a quick return to trend growth, debt ratios would continue to rise. Without sustained consolidation efforts, there is the definite threat of running into a debt trap longer term. The Maastricht norm will be obsolete for years to come. Even if the primary balance in Germany were to be 2 percentage points higher than in our base case, it would take 20 years before the debt ratio falls below 60% again.

  • Market reactions. It is, however, not only future generations that will be saddled with the burdens. There is already the threat of tangible market reactions in the shorter term. Ballooning budget deficits drive up inflation expectations, resulting in increasing government bond yields. Furthermore, investors – in the case of the US primarily foreign investors – will presumably not accept a meager yield for much longer. High or rising twin deficits are, moreover, poison for the USD on a longer-term horizon.

  • Further topics:

    Weekly Comment: The OECD versus the ECB (page 2).

    US: Business investment restraint will retard recovery (page 13).

    Data outlook: EMU-wide economic climate to improve slowly; more layoffs in the US again (page 15).

    Market outlook: Yield curve to steepen; EUR-USD at 1.40 (p. 23).

The OECD versus the ECB

On Wednesday, the first ECB 12-month refinancing operation was a success: While there was a wide range of expectations on the likely take-up, the EUR 442 bn allocation represents a substantial amount, and confirms that this new 1-year refinancing is an important addition to the ECB’s arsenal. The ECB remains focused on the need to ensure sufficient and reliable longer-term funding to the banking sector, and both the longer maturity refinancing operations and the covered bonds purchase program go in this direction. While I would also have favored a more transparent zero interest rate policy, there is no doubt that these quantitative measures are very well targeted and should prove effective in averting the risk of a credit crunch. The launch of the ECB’s 1-year refinancing operations should allow for some more narrowing of eurozone money market spreads, whereas EUR-USD remains rangebound. Credit will play a pivotal role in the coming months: The banking sector will come under pressure because of the rise in NPLs (nonperforming loans), and a tightening of credit supply just as the real economy attempts to stabilize would be extremely damaging. The ECB appears to be well aware of this and is reacting appropriately. Meanwhile, the OECD forecasts confirm that key emerging markets will display the fastest and strongest exit from the recession, followed by the US – in fact, the somewhat brighter prospects for the US are the main reason for the improvement in the OECD’s forecasts. The OECD also calls on some countries to provide further fiscal stimulus, and identifies Germany as one of the countries that should do more, in sharp contrast to the German government’s emphasis on the need for consolidation.

Next week, the ECB will once again be under the spotlight. It will almost certainly keep its policy unchanged, holding the Refi rate at 1.0% and refusing to commit to any increase in the covered bonds asset program. In so doing, the ECB will continue to expose itself to the criticism that since it is willfully aiming to undershoot its inflation target, given that its own staff forecasts point to HICP at just 1.0% next year. However, the ECB will not be ready to provide further stimulus just as the data start to indicate a stabilization of economic activity – especially as its new, longer term liquidity provisions promise to support credit supply. Meanwhile the Fed stays the course, with no major changes in the FOMC statement released this week. In particular, the statement still includes the key sentence “…economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period”, and re-affirms the existing targets for asset purchases. Nearly two months after the previous statement, the Fed shows no great enthusiasm for the additional signs of stabilization: The assessment of economic activity is largely unchanged, with activity likely to remain weak for some time – although the Fed reiterates its confidence that policy action and market forces will successfully restore growth, eventually. The FOMC statement scales down the risk of deflation or persistently low inflation: the Fed now believes that “inflation will remain subdued for some time”, whereas in April it saw “…some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.” On this note, the statement acknowledges the recent rise in commodity prices, but remains confident that this will be offset by “substantial resource slack”.

So the statement is imperceptibly more hawkish, but overall confirms that the Fed is in no hurry at all to launch an exit strategy, and we would expect markets to push further back expectations of rate hikes, as we have already seen in the past days. As discussed last week, we are set for a prolonged wait-and-see period, with the Fed on hold and the markets nervously watching.

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