Even as the world economy is recovering from a meltdown, a sovereign debt crisis threatens to send it into turmoil again. Rising concerns over sovereign debt underline the need for credible fiscal adjustment by troubled governments sooner rather than later.
Whenever the world economy faces financial crises, social unrest or the boom-bust cycles of commodities, there is characteristically a wave of sovereign defaults. It is no different this time too. In the process of settling the dust from the great financial crisis, a new risk has emerged—skyrocketing government debt around the world. The deep global recession and massive fiscal pumping have put significant strain on the fiscal deficits of the US, Europe, Japan and some emerging economies. Some of them are facing the government debt to GDP ratio double-digit levels, leading to sovereign risk pressures due to fear that the unsound fiscal imbalances could prompt a crisis similar to the 1982 Mexican debt crisis. In the past, some countries like Spain and Austria learnt their lessons, but countries like Argentina are yet to learn.
Statistics indicate that sovereign debts have totaled more than $35 tn worldwide, with the debt-to-GDP ratio hitting a record high. Major economies include the US, the UK, Germany and France facing record debt due to large aggregates in their public debts. Meanwhile, credit rating agencies cut the sovereign debt rating for Mexico, Greece, Portugal and Spain after the Dubai government abruptly announced its plan to delay debt payments in November 2009. Fitch Ratings assert that “the extraordinary sovereign intervention and support for the financial sector, as well as fiscal stimulus packages and the severity of the recession, have weakened high-grade sovereign credit profiles, making 2010 a tough year for governments throughout the world.”
Financial crisis combined with severe economic recession, worsened the fiscal position of many western economies because of stimulus packages and lower tax revenues to support the financial sector. Skyrocketing government debt is promoting calls for stimulus withdrawal. In fact, it is not stimulus spending, falling output is the main cause of wider fiscal deficit in many western countries. The impact is even severe in countries with fiscal structure problems, loose monetary policies adopted in the wake of financial crisis and neglected fiscal reforms during the boom years. There is a growing concern about the risks related to western economies debt burdens as political assurance to curb spiraling debt remains in doubt. At this juncture, a sovereign debt default somewhere in the world could be a potential force and cause the feathering global recovery to stagger.
Economists warn that even if developed nations avoid outright default, their credit ratings could be slashed which result in raising borrowing and intensifying economic underperformance. Financial woes in Dubai and Greece may be just a harbinger of other stories which might unfold later in 2010. The recent credit ratings downgrades and debt auction failures in the UK, Greece, Ireland and Spain warn that unless developed economies start to put their fiscal houses in order, investors and rating agencies would probably turn from friends to enemies. Feeble economic recovery and ageing population is likely to increase the debt burden in Japan, the US and the UK and several other Eurozone countries in the coming days.
According to IMF recent report, public debt in advanced G20 economies will rise from 78% of GDP in 2007 to 118% in 2014. It suggests that even faster growth would help slow the rise in debt but would not break it, underscoring the need for increased taxes and reduced discretionary spending. Accordingly, sustaining growth should remain top priority if they want to break the debt spiral.
New phase of global crisis
Greece is at the center of the sovereign debt crisis. Global slowdown has made the difficulties of the euro become more prominent, particularly for the peripheral areas of the 16-nation Eurozone countries including Portugal, Ireland, Italy, Greece and Spain. After Greece joined the EU and adopted the euro in 2001, it went on a borrowing binge. When bond rating agencies downgraded the country’s debt in December 2009, it was running a budget deficit amounting to 12.7% of GDP which is higher than that of Spain and twice the Eurozone average. Portugal budget deficit has peaked substantially higher than previously forecast at 9% of GDP, while Spain’s deficit for 2009 will be 11.4%. The skyrocketing debt of these nations is raising questions about the viability of the euro itself. There is increasing public speculation that the 11-year-old currency could collapse under the pressure of the economic and financial crisis. The Greece sovereign debt crisis has stoked worries about EU members with high debt levels, particularly Portugal, which is now suffering political crisis, in what one pundit fancifully called another round of Eurozone sovereign debt whack-a-mole. The problem is even more for trading nations like Canada, a major producer and exporter of commodities as their price movements have a big impact on nominal GDP and government revenues.
Analysts ponder that these countries’ budget deficit issues concern more fundamental economic problems that could jeopardize the future of the euro and stifle global growth as weaker Eurozone members will throw the world economy into a ‘double-dip’ recession.
Island’s debt at risk
Though markets are nervous about holding the sovereign debt of the smaller Eurozone members, these problems should prove manageable if the region continues to recover. However, among the major economies, Japan offers the greatest source for worry in the near future. Though Greece is just the starter of the debt crisis, Japan is the first country to feel the pinch as the debt-to-GDP ratio has grown from 65% in the early 1990s to over 200% now, the highest among advanced economies.
The IMF says Japan’s gross public debt to reach 227% of GDP in 2010 and warned that market concerns over fiscal sustainability and political uncertainty have led to a widening of credit default swap spreads. Japan’s debt burden is a legacy of massive government spending in the 1990s after the asset bubble burst which led to a decade of stagnation. In the recent past, rising ageing population have added considerably to the debt burden. Fortunately, Japan has almost no foreign currency-dominated debt obligation as the high savings rate has allowed governments to finance the deficit internally. Analysts say, “this is the key reason why Japan gets away with paying only 1.3% on their 10-year bonds when other large OECD countries must pay 3-4% to attract investors.”
Like Japan, India has a high government debt to GDP ratio of 75%, but it is financed almost entirely from domestic funds given its high savings. However, JPMorgan Chase Analyst Masaaki Kanno in Tokyo says that “Japanese bonds are in a bubble that could pop in the next three to five years, as savings rates drop. Even if the government can somehow keep borrowing at a 1.4% interest rate, interest expense will rise to roughly $200 bn by 2019, or 45% of government revenue, unless it pushes through a big increase in the national value-added tax.” However, those rates are unlikely to hold as the Japanese government has been able to replace bonds paying as much as 7% interest with steadily lower-rate debt over the years.
Is the US next?
Amidst pan-European debt spiral, there are reigniting fears that the US could be next and there is no easy way out from debt crisis. The Congressional Budget Office (CBO) forecasts a whopping $1.6 tn deficit this year, which would come to 10.6% of GDP, the worst in modern times. Just like other developed nations, the US government responded to the financial crisis by taking on the debts of banks and essentially bankrupting its treasury in order to preserve the wealth of its financial elite.
Now the Obama administration like the governments of Europe is demanding that the cost be borne by the general public in the form of sweeping cuts in basic social programs and a reduction in consumption. Many economists warned in 2009 against the US policy of flooding financial markets with cheap credit on the basis of near-zero interest rates and the electronic equivalent of printing a trillion dollars—designed to prop up the major US banks and enable them to record bumper profits despite double digit unemployment. Benn Steil, Senior Fellow at the Council on Foreign Relations and author of Money, Markets and Sovereignty says: “The economy over the last six months has been on a sugar high. If Congress and the Obama Administration don’t trim deficits, Americans will get to the point where credit is much more expensive in the US than it ever has been in the past.” Many struggling states and local governments are already having trouble paying their bills are turning to Washington for financial aid. Brian Coulton, Head of global economics at Fitch Ratings in London warns that once rock-solid economies like the US and the UK could join shakier nations like Japan and Ireland in losing their ‘AAA’ ratings, if they don’t get their bad habits under control. However, economists like Paul Krugman have argued that US debt remains manageable at current levels.
Stifling recovery matters
The big question that pundits are discussing is the impact of soaring government debt on the global economy and more importantly, how governments around the world are likely to deal with their fast looming debt obligations. They are of the view that it is not possible to reduce that debt too quickly without stifling global economic recovery.
If the US economy witnesses a fairly robust recovery, then the deficit should go down on its own. However, western economies must consolidate considerably their government spending over the next two or three years. Ian Stewart, Director, Deloitte Research, UK suggests that “the ideal solution would be to have a credible plan to gradually reduce that deficit over time, so that financial markets would be convinced that it wouldn’t be a problem in the future.” If this does not happen, governments in these countries have to face large deficits and will have to compete with private investors for scarce funds and will drive up long-term interest rates. A balanced budget is the need of the hour for sovereign entities to avoid a serious debt bubble burst.
However, given record unemployment levels, feeble economic recovery may probably prevent any drastic measures like mild interest rate hikes to squeeze liquidity and stabilize financial market. Governments have to constitute a feasible and reliable solution to avoid a new round of trust crisis from the markets regarding their capabilities in containing deepening public debts.
Future
Sovereign default of any nation could mean economic disaster as funding sources dry up. Altogether it will lead to significant unemployment levels as infrastructure projects would come to a standstill and a social and political disorder cannot be ruled out. The tremors of subprime meltdown and the collapse of mighty financial institutions continue to ripple through the financial markets and the global economy. Governments poured immense amounts of taxpayer funds to prevent succeeding crises. But they accomplished it at a big price—dreadful sovereign debt hanging over most of the western world and racking financial pain and feeble economic growth. The financial crisis and resulting economic recession have created a more vulnerable environment where today’s risks may become tomorrow’s crises.
N Janardhan Rao, Senior Economist.
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