Sovereign debt crisis at ‘boiling point’, warns Bank for International Settlements
by Ambrose Evans-Pritchard, Telegraph Online
Originally published 08 Apr 2010
THE BANK FOR INTERNATIONAL SETTLEMENTS DOES NOT MINCE WORDS. Sovereign debt is already starting to cross the danger threshold in the United States, Japan, Britain, and most of Western Europe, threatening to set off a bond crisis at the heart of the global economy.
“The aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to the boiling point”, said the Swiss-based bank for central bankers – the oldest and most venerable of the world’s financial watchdogs. Drastic austerity measures will be needed to head off a compound interest spiral, if it is not already too late for some. The risk is an “abrupt rise in government bond yields” as investors choke on a surfeit of public debt. “Bond traders are notoriously short-sighted, assuming they can get out before the storm hits: their time horizons are days or weeks, not years or decade. We take a longer and less benign view of current developments,” said the study, entitled “The Future of Public Debt”, by the bank’s chief economist Stephen Cecchetti.
“The question is when markets will start putting pressure on governments, not if. When will investors start demanding a much higher compensation for holding increasingly large amounts of public debt? In some countries, unstable debt dynamics – in which higher debt levels lead to higher interest rates, which then lead to even higher debt levels – are already clearly on the horizon.”
Official debt figures in the West are “very misleading” since they fail to take in account the contingent liabilities and pension debts that have mushroomed over recent years. “Rapidly ageing populations present a number of countries with the prospect of enormous future costs that are not wholly recognised in current budget projections. The size of these future obligations is anybody’s guess,” said the report. The BIS lamented the lack of any systematic data on the scale of unfunded IOUs that care-free politicians have handed out like confetti.
Britain emerges in the BIS paper as an arch-sinner. The country may have entered the crisis with a low public debt but this shock absorber has already been used up, exposing the underlying rot in the UK’s public accounts. Tucked away in the BIS report are charts and tables showing that Britain faces the highest structural deficit in the OECD club of rich states, with a mounting risk that public debt will explode out of control.
Interest payments on the UK’s public debt will double from 5pc of GDP to 10pc within a decade under the bank’s ‘baseline scenario’ before spiralling upwards to 27pc by 2040, the highest in the industrial world. Greece fares better, and Italy looks saintly by comparison. The BIS said the UK’s structural budget deficit will be 9pc of GDP next year, the highest in the advanced world. A primary surplus of 3.5pc of GDP will be required for the next twenty years just to stabilize the debt at the pre-crisis level.
The paper said that Labour’s plan to consolidate the budget deficit by 1.3pc of GDP annually for the next three years is not nearly enough. Such a gentle squeeze will let public debt climb to 160pc of GDP by the end of the decade, accelerating to 350pc over the following twenty years as the compound interest trap closes in. “Consolidations along the lines currently being discussed will not be sufficient to ensure that debt levels remain within reasonable bounds”, said the bank. While the comment covers a group of countries, it is clearly aimed at Britain. The analysis bolsters claims by the Tories that markets will not wait patiently as Britain draws up leisurely plans for austerity-lite, relying on implausible turbo-growth to do the hard work of cutting the deficit.
Fitch Ratings has made the same point, asking why the UK thinks it has a longer grace period than peers in Europe. Spain has pledged to cut its deficit from 11.4pc to 3pc in three years in line with Maastricht rules.
Perhaps the most shocking detail in the BIS paper is that the UK’s debt will rise to 300pc of GDP by 2040 under this moderate fiscal squeeze even if it is accompanied by a freeze on age-related spending. Britain – unlike Greece – can no longer rely on soft measures to cut the structural deficit, such as increasing the share of women in the work force. Such low-hanging fruit has mostly been picked already.
The BIS, in charge of monitoring global capital flows, said public debt has risen by 20pc to 30pc of GDP across the advanced economies over the last three years. Semi-permanent structural deficits have taken root. “Current fiscal policy is unsustainable in every country (in its study). Drastic improvements in the structural primary balance will be necessary to prevent debt ratios from exploding.”
Average debts will exceed 100pc of GDP by the end of next year. The level was briefly higher in the US and the UK after World War Two. Japan is currently able to raise money cheaply at even higher debt levels thanks to its captive savings pool. However, the BIS said it would be foolhardy to assume that debt markets will tolerate this for long.
The BIS said the usual cure for budget deficits is a return to robust grown and lower nominal rates. Neither are likely for OECD economies this time. The West has slipped to a lower growth trajectory. Historical data shows that once public debts near 100pc of GDP they act as a ball and chain on wealth creation. If countries do not retrench quickly, they will create a market fear of “monetization” that becomes self-fulfilling. “Monetary policy may ultimately become impotent to control inflation, regardless of the fighting credentials of the central bank” it said.
Some states may be tempted to carry out a creeping default by stoking inflation. “The payoff to do this rises the bigger the debt, the longer its average maturity, the bigger the fraction held by foreigners.” The BIS said the danger that any government would consciously take this path is “not insignificant” in the longer run. Of course, a brutal fiscal purge in every major country at once itself poses a danger. The result would be to crush recovery and tip the world economy back into crisis, making deficits worse again. Countries are damned if they do, and damned if they don’t.
The BIS skips nimbly over this dilemma. Nobody has yet mastered our horrible Hobson’s Choice.