Wednesday, February 17, 2010

BIS Economists on "The Future of Public Debt"

Public debt and spending has become a particularly hot topic recently. The key driver is a ballooning of fiscal deficits on the back of the crisis. Governments around the world have transferred troubled assets from the private sector to the public sector in order to prevent a major meltdown, they have also taken large moves to stimulate demand. But this has worsened existing vulnerabilities in terms of fiscal sustainability. Hot spots have flared up like Greece and Dubai. The worse may still be yet to come.

In these times it is prudent to soak up new information and insights to position yourself to not only avoid loss but, if possible, make gains. This is a review of a BIS (Bank for International Settlements) conference paper entitled "The Future of Public Debt: Prospects and Implications", by Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli. This new resource should provide some insights and warnings about the future of government balances and debt positions for investors and strategists. The paper can be found here.

There are a few good charts and tables in the paper which outline current and projected positions under various scenarios e.g. interest expense as a fraction of GDP, inflation expectations, industrial economies' gross public debt and primary fiscal balances, projected population structure and age related expenditure, CDS spread regressions against various fiscal indicators. I've taken two visuals from the report to discuss in this review:

The first one shows projected public debt to GDP, the red dotted line is the baseline scenario, green is a small gradual adjustment, and blue is a small gradual adjustment with age-related spending held constant. There are charts like this for 12 countries, I picked out these two in particular because they're traditionally seen as solid and safe countries/markets. But if you look at the UK in particular, if things do indeed unfold like this there will be implications (mention these soon), and remember in markets things tend to get priced in earlier than expected...

It's also worth noting that they found in studying CDS market data that CDS (default risk) spreads were reliably correlated with debt to GDP ratios (whereas previous studies, prior to CDS data coming available, had identified that "For each percentage point of additional public debt, researchers estimate a risk premium increase of between 1.6 and 1.2 basis points.").

I also thought the above table would be interesting to include as it shows the magnitude of just how hard it will be to solve the problem in the near term. The standouts are the UK, Japan, and Ireland - who would each need to run primary balance surpluses of at least 10% over the next 5 years. Not only would this be politically difficult to do, but it would also adversely impact economic growth (as decreased spending and higher taxes obviously would have the reverse impact of stimulus measures).

But then who would expect the politicians to take the hard road? It's interesting to see their discussion of issues around fiscal challenges and monetary policy: "two channels through which unstable debt dynamics could lead to higher inflation – direct debt monetisation and the temptation to reduce the real value of government debt through higher inflation." It seems to me that there is a non-zero probability risk of this sort of 'approach' going on at some point.

The other key risks or warnings they discuss, to briefly mention, include:

"In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly."

"large public debts have significant financial and real consequences. The recent sharp rise in risk premia on long-term bonds issued by several industrial countries suggests that markets no longer consider sovereign debt low-risk."

"the risk that persistently high levels of public debt will drive down capital accumulation, productivity growth and long-term potential growth potential."

It's well worth reading the entire paper, as a lot of detail is missed in this brief review - but hinted at. A key theme of the paper is that prior to the crisis a lot of industrialized nations faced existing structural deficit problems such as the future liability of unfunded aging population related expenses (e.g. pensions, rising health care costs etc). Of course when you add crises to the mix - which tend to increase government deficits and debt (as noted in a study they cited) - the existing problems of structural imbalances only become harder to deal with.

As we're seeing some of the potential problems unfold in places like Greece, it is therefore necessary to be vigilantly mindful of trends in government spending to set intelligent investment strategy. At the end of the day as an individual you're probably powerless to alter the course of government policy, but you can and should alter the course of your own personal policies...

"The Future of Public Debt: Prospects and Implications"
Bank for International Settlements

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