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Investors face defaults on government bonds given
the burden of ageing populations and the challenge of increasing tax revenue,
according to a Morgan Stanley executive director based in London. Ireland's debt
to government revenue ratio is high but lower than US.
Arnaud Marès, who has worked at the UK's debt
management agency, says that the conventional debt/GDP (gross domestic product)
ratio does not compare debt to a government’s ability -- or willingness - -
to pay. When measured against government revenue, the US debt position, for
instance, is worse than Greece’s and Ireland is third in a ranking of 9
The sovereign debt crisis is not European: it is global. And it is
not over. Marès says the European sovereign debt crisis of spring 2010 was a
misnomer in more ways than one: there was not one crisis but two. And it
will continue well beyond 2010, in the MS view. The first crisis was, and
remains, an institutional crisis of the euro, caused by a flawed
multilateral fiscal surveillance framework. Steps have been taken towards a
correction of the flaws with a move from peer pressure to peer control of
fiscal policy. The second crisis was, and remains, a sovereign debt crisis: a
crisis caused by sovereign balance sheets being overstretched, to the point
where insolvency ceases to be merely possible and becomes plausible. This
crisis is not limited to the periphery of Europe. It is a global crisis and
it is far from over. We take a high-level perspective on the state of
government balance sheets and conclude that debt holders have to be prepared
to enter an age of ‘financial oppression'.
Debt/GDP has been higher before, so why worry? Marès says as government
debt and deficits have swollen to levels for which there exist few recent
references, all eyes have turned to a more distant past in the hope of finding
some guidance as to what future awaits bondholders. At first glance, history
appears to be reassuring, though that is deceptive. Several
advanced countries have experienced debt/GDP levels well in excess of current
ones. The US emerged from Word War II with a public debt/GDP ratio of
approximately 110%, and the UK with a ratio of 250%. The UK national debt has
averaged almost 100% of GDP since its creation in 1693. Yet the UK
government never defaulted through that period. France's public debt stood at
about 280% of GDP at the end of World War II. It did not default either. As a
matter of fact France defaulted only once - in 1797 - since the creation of its
own national debt in 1789. This is remarkable, considering the number of
political, military and economic crises the country went through. So why worry
now he asks?
Four reasons why debt/GDP misses the point. The problem with
these historical comparisons is not the reference: how governments dealt with
their war debt burdens sheds useful light on what might be in store for coming
years. Rather, the problem lies with the measurement tool: debt/GDP is the most
widely used debt metric, but Marès
says it is a very inadequate indicator
of government solvency. There are four reasons for this:
Gross versus net debt:
First, debt/GDP is a
measure of gross indebtedness. It therefore overstates the size of the
government's net financial liabilities, especially when - - as has been the case
through the crisis - - debt is being raised for the purpose of on-lending or
acquiring assets. Where measures of net debt exist, they provide an apparently
less alarming picture of the government's balance sheet. The difference can be
sizeable (in excess of 17% of GDP in the UK currently, for instance). Good news,
however, stops here.
Missing liabilities: The second flaw of debt/GDP
is that it only accounts for part of a government's contractual
liabilities. There exists a broad range of liabilities that are debt, yet are
not captured in national accounts. To take one example, in March 2008 the UK
Government Actuary Department valued the government's unfunded civil service
pension liabilities - that is, the contractual claims on government accumulated
to date by civil servants - at £770 billion. That is 58% of GDP, not captured by
the debt/GDP ratio. Debt/GDP does not capture contingent liabilities either.
It is not GDP but government revenues that matter:
Whatever the size of a government's liabilities, what matters ultimately is how
they compare to the resources available to service them. One benefit of
sovereignty is that governments can unilaterally increase their income by
raising taxes, but they will only ever be able to acquire in this way a fraction of GDP. Debt/GDP therefore provides a flattering image of
government finances. A better approach is to scale debt against actual
government revenues. An even better approach would be to scale debt against the
maximum level of revenues that governments can realistically obtain from using
their tax-raising power to the full. This is, inter alia, a function of
the people's tolerance for taxation and government interference. Seen from this
angle, the US federal debt no longer compares quite so favourably with that of
Debt/GDP looks at the past. The main problem is in the
future: The fourth and largest flaw of debt/GDP is that it is an
entirely backward-looking indicator. It only accounts for the accumulation of
past deficits. This captured reasonably well the magnitude of the fiscal
challenge at the end of World War II because at that time the challenge did
indeed result entirely from the past: large wartime deficits had pushed debt
ratios higher, but governments were no longer running deficits, nor were there
expectations of them doing so in subsequent years.
By contrast, the accumulation of past deficits now represents only part
of the problem for advanced economies' governments. The other part consists of
coping with the large structural deficits opened up by the crisis and compounded
by the fiscal consequences of ageing. What raises questions about debt
sustainability is not so much current debt levels as the additional
debt that will accumulate in coming years if policies do not radically change.
Debt ratios do not capture this part of the problem.
The European Union has
received a letter from nine of its members calling for a change in the way the
debt of EU countries is calculated. Peter Attard Montalto from Nomura has
Looking beyond debt: valuing government equity. Marès says a comprehensive look at
government balance sheets provides a much gloomier reading of their solvency. He
says the difference between the
power to tax and the social liability is the net present value of all future
structural primary deficits (by definition, the cyclical component of the
deficit should sum up to zero over time).
The residual is represented on the balance sheet as the people's equity, by
analogy to a corporate balance sheet. This is effectively the net worth of the
government in the broadest sense, and a measure of its solvency. It can be
interpreted very simply as follows: if positive, the government can release
value to taxpayers by lowering taxes without reneging on its promises to other
stakeholders (bond holders and beneficiaries of public services). If negative,
the government is insolvent. In other words, some or all of its stakeholders
must suffer a loss: either taxpayers (through a higher tax burden), or
beneficiaries of public services (through lower expenditure) or bond holders
(through some form of default).
Adding the cost of ageing to that of the crisis. An estimate
of government ‘equity' value can be obtained by adding the net present value of
all future primary deficits to existing financial debt. Future primary deficits
result from two influences:
Current structural deficits, opened up or aggravated
during the crisis by the permanent loss of tax revenues that accompanies a
permanent loss of output. This is the part of the deficit that will remain -
once temporary stimulus measures are withdrawn and growth has returned to trend
- under an assumption of unchanged policies;
The additional structural deficit that - under the same
assumption of unchanged policy - would gradually result from ageing, mostly
through a rise in health and pension expenditure.
Marès says the fiscal challenge is unprecedented.
He provides illustrative estimates of
government net worth under this approach. What matters here, he says, is not the exact
numbers, which are very dependent on underlying assumptions. What
matters is the sign of net worth (negative everywhere), its broad order of
magnitude (a large multiple of current or historical debt levels almost
everywhere) and the ranking of governments.
This depressing perspective on global public finances is not exactly news.
The same calculations based on pre-crisis data were not nearly as bad, but not
significantly more encouraging either, with most governments already then in
negative equity. The crisis has had three noticeable effects nonetheless:
It has aggravated the problem everywhere, mostly through a
permanent shock to tax revenues and through a transfer of liabilities and risk
from the private to the public sector, without a commensurate transfer of
In doing so, it has intensified the inherent conflict that exists
between bond holders and other government stakeholders that all compete for
resources that are finite and, crucially, insufficient to satisfy all their
claims - to the point where holders of government debt have started
contemplating default as a plausible outcome rather than a mere theoretical
...which, in turn, considerably shortened the time available to
governments to resolve this conflict one way or the other, with a loss of market
access a credible penalty for procrastination.
It is not whether to default, but how, and vis-à-vis whom.
Marès says what this means is that - as indicated above - governments will impose a loss on
some of their stakeholders and have in fact started to do so (across Europe at
least). The question is not whether they will renege on their promises, but
rather upon which of their promises they will renege, and what
form this default will take. From the perspective of sovereign debt holders,
this translates in two questions:
Does their claim on governments rank senior enough relative to
other claims to fully shelter them from losses?
If it does not, what form will this loss take?
Bonds remain the most senior government liability.
The MS director says there are
good reasons why government bonds should rank senior to most other liabilities.
To mention one: governments need to be able to raise finance to fund public
investment as well as to perform their macroeconomic stabilisation role. They
cannot issue equity, and cannot credibly issue secured debt. Unrestricted access
to unsecured, confidence-based funding is core to their ‘business model', as it
is for banks. This was, historically at least, the main argument for honouring
sovereign debt. There are others, not least the consequences of a government
default for output and for financial stability when banks own substantial
exposure to the sovereign.
Bond holders have been fully sheltered from loss through the Great
Recession - so far. The MS director says this seems consistent with historical experience,
both from yesteryear and yesterday. So far indeed, holders of sovereign debt
have been exempt from sharing in the loss of income and wealth that has affected
everybody else: shareholders have absorbed direct losses. Homeowners have faced
(uneven) losses of property value. Taxpayers have experienced a reduction in
their lifetime income through current and prospective increases in taxation.
Government employees and other stakeholders are suffering even larger losses
through current or prospective reduction in government expenditure. Only holders
of senior unsecured debt issued by the largest governments and - in most cases -
banks have been sheltered so far.
Can this realistically continue forever?
He says this is ultimately
a question of political economy and adds itt is worth noting that, in the case of Greece,
public acceptance of austerity measures - cuts in civil service compensation in
particular - has become conditional on the perception that the cost of fiscal
retrenchment would be distributed fairly across constituencies (hence the very
public crackdown on wealthy tax evaders). Whether and when bond holders are
asked to share in the common pain - not just in Greece - depends on:
The intensity of the conflict that opposes them to other
stakeholders. As discussed earlier, this is likely stronger than it has ever
The extent to which the interests of bond holders are aligned
with those of the most politically influential constituencies.
Financial oppression as an alternative to outright default.
Marès says outright default is not the only
way to impose losses on creditors. Financial oppression - - the fact of imposing
on creditors real rates of return that are negative or artificially low - - can
take other forms: repaying debt in devalued money (e.g., through unanticipated
inflation), taxation or regulatory incentives on institutions to purchase
government debt at uneconomic prices, for instance. Repaying debt in devalued money is particularly effective
when the initial stock of debt is high - as it is now. Distorting prices in the
government's favour is particularly effective when the financing requirement is
high - also a situation we face now and for years to come.
History is not so reassuring after all.
He says financial oppression
has taken place in the past as an alternative to default in countries that are
generally considered to have a spotless sovereign credit record. Examples
include: the revocation of gold clauses in bond contracts by the Roosevelt
administration in 1934; the experience by then Chancellor of the Exchequer Hugh
Dalton of issuing perpetual debt at an artificially low yield of 2.5% in the UK
in 1946-47; and post-war inflationary episodes, notably in France (post both
world wars), in the UK and in the US (post World War II). Each took place at a
time when conflicting demands on finite government resources were high, and rentiers wielded reduced political power.
The interests of bond holders are no longer perfectly aligned with
those of the most powerful constituency. Marès considers the rapid
increase in the age of the median voter in large western European countries. In
principle, having governments and policies shaped by older voters ought to be favourable to bond holders, because bonds are more likely to be held by the old
than the young and policies that would harm bond holders would often also harm
the old (inflation for instance redistributes wealth from the old to the young).
He says the first problem with this argument is that the constituency of the elderly is
also the biggest competitor to bond holders because of the considerable size of
the direct claim it has on the government balance sheet in the form of pensions,
social security and health insurance, etc. The more reluctant they are to
relinquish these claims, the higher the risk for bond holders. The second
problem is the dilution of bond ownership, which results in lesser alignment of
the interest of bond holders with older voters: even in the UK, where the
domestic and pension industry has traditionally dominated the gilt market, its
ownership of gilts has decreased in recent years from around 60% to 40% of the
market (excluding Bank of England purchases), to the benefit of foreign
No insurance against financial oppression at current yield levels.
Against this background, Marès says it seems dangerously optimistic to expect that
sovereign debt holders can be continuously and fully sheltered from partaking in
the loss of wealth and income that has affected every other group. Outright
sovereign default in large advanced economies remains an extremely unlikely
outcome, in our view. But current yields and break-even inflation rates provide
very little protection against the credible threat of financial oppression in
any form it might take. He says that a double-dip recession would not invalidate
this conclusion: it would cause yet further damage to the governments' power to
tax, pushing them further in negative equity and therefore increasing the risks
that debt holders suffer a larger loss eventually.
Arnaud Marès does not consider the implications for interest rates of increasing defaults and in recent times, economists at MS' rival Goldman Sachs predicted that global interest rates will stay low for at least 20 years:
Appendix Estimating Government Net Worth: Underlying Assumptions
MS illustrative estimates of government net worth are based on the following
Initial debt level:
For the purpose of simplicity,
consistency and availability of data across countries, MS uses the projected debt
level of gross debt/GDP at end-2010 - even though the correct aggregate to use
here is clearly net financial debt. This has no material bearing on the
conclusions of the exercise.
Structural deficit: The exact size of the structural deficit is a guesstimate
at best - it requires an assessment of potential GDP, a notoriously imprecise
concept. Calculations are based on official projections of cyclically adjusted
primary deficits in 2011, and MS assumes that this deficit is unchanged in every
subsequent year (as a percentage of GDP). This is consistent with the assumption
of ‘unchanged policy'. In practice governments do intend to change policy - - and
thereby to reduce the size of the structural deficit. In doing so they inflict a
loss on taxpayers (if raising taxes) and on other stakeholders (when cutting
expenditure). As the purpose of the exercise is precisely to evidence the
magnitude of the loss that these will suffer, assuming an unchanged structural
deficit at current levels is the appropriate reference point. It is for this
same reason that MS uses as a reference point 2011 and not 2010 data: the latter
is still distorted in some countries by stimulus measures, which, being
temporary by nature, never constituted a ‘promise to spend'. The removal of the
stimulus measure does not therefore inflict on stakeholders a loss as MS defines
Cost of ageing: Estimates of the cost of ageing on public
finances - even under unchanged policy - - rely heavily on demographic and
economic projections. For the purpose of our illustrative calculations, MS used
long-term projections of age-related expenditure published by the EU and - - for
the US - - by the IMF. For the same reason as above, the reference point is
pre-fiscal retrenchment, i.e., the calculation does not take account of the
ongoing pension or healthcare reforms decided or being discussed this year in
Discount rate: The net present value of future fiscal
deficits is naturally heavily dependent on the discount rate used. The
calculations assume a discount rate 100bp (1%) above the nominal GDP growth rate
across all countries.