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One of the underlying assumptions of the Fed's and many other central banks' response to the credit crisis is that it can be halted, and hopefully remedied, by having the government backstop the troubled financial sector. One template is not to repeat the supposed mistakes of the Great Depression and Japan's post bubble era, where conventional wisdom has it downturn morphed into disasters as a result of the failure of central banks to break glass and supply liquidity aggressively enough. A second model is Sweden. There, the government intervened aggressively to combat a large scale banking crisis by nationalizing failing banks (they had a methodology for doing triage, to determine who could be saved and who needed to be liquidated or merged), spun the bad assets off into a liquidation vehicle, recapitalized what remained, and sold them off when the economy recovered.
However, these paradigms are being applied selectively, with the politically convenient bits being implemented and the harder remedies ignored. The Fed moved quickly to cut rates and then create special vehicles to help provide liquidity to markets that appeared stuck. But this response came out of both Bernanke's study of (one might say fixation with) the Depression. plus the "if the only tool you have is a hammer, every problem looks like a nail" syndrome. Central banks are in the liquidity business, so they tend to fall back on the tools they have at hand, rather than going to the more difficult process of building political support for other types of solutions.
For instance, a number of observers, ranging from Depression expert Anna Schwarts and the Japanese have taken issue with the heavy reliance on liquidity injections. Schwartz has pointed out, as many others have, that the current financial meltdown is not a liquidity crisis but a solvency crisis. Both Schwartz and the Japanese recommended approaches that put much greater priority on purging bad assets (Schwartz recommended letting insolvent firms fail, while the Japanese urged speedy recapitalizations).
And even the Swedish approach, which is now being given lip service, is largely ignored. One of its key elements was that the banking system had grown disproportionately, unsustainably large, and needed to be shrunk. The US, by contrast, is not only trying to prop up the financial system in place, but also wants it to make more loans to keep the economy going. In other words, they want to make the underlying problem of overleverage worse.
Since the US looks borrowings relative to GDP are higher than Sweden's were at the time of its crisis, the need to figure out how to reduce indebtedness is crucial. Some analysts have pegged US debt to GDP at 350%; reader Bjornar kindly did some digging, and based on this and this source concluded Swedish debt to GDP in 1990 was roughly 170%. While both estimates are admittedly quick and dirty, the obvious shortcomings in the US estimate suggest it is, if anything, understated.
However, reducing indebtedness means a lower GDP, when the idea of letting growth suffer is anathema. Yet Sweden, which is widely held as a model, did in fact have a very nasty two year recession, but had a strong rebound afterwards. Most analysts believe this was the least costly approach, in terms of long-term consequences. Yet the US seems determined to minimize immediate pain, not matter how great damage to long-term economic health.
Moreover, the US is starting to get warning signs that it may encounter resistance from our friendly foreign funding soruces when we ask them to pick up the tab for our debt party. Willem Buiter, who was a front-row spectator in the Iceland meltdown (he and Anne Siebert were bought in to advise the authorities late in the game, and they evidently didn't heed Buiter's and Sieber's advice) warns that having the government rescue the banking sector does not reduce risk but merely transfers it, and investors are wising up:
Under current circumstances, if the government injects capital into a bank to compensate for past and anticipated future losses, it may not achieve a risk-adjusted expected rate of return on this investment equal to its borrowing cost. The difference will have to be recouped through higher future primary surpluses, that is, higher future government budget surpluses excluding interest payments. If there is doubt in the markets about the ability or willingness of current and/or future governments to raise future taxes or cut future spending to generate the required increase in future primary surpluses, the default risk premium on the public debt will rise. We are seeing such increased default risk premia even for the most credit-worthy sovereigns, including the German government, the US government and the UK government. On Friday October 10, 2008, the spreads on 5 year sovereign CDS were 0.456% for the UK, 0.33% for the USA ad 0.265% for Germany, well above their post-war historical averages. On October 28, 2008, Bloomberg wrote:
Credit-default swaps on [U.S.] Treasuries have risen nearly 40 percent since TARP was signed into law Oct. 3, and are now about the same as Mexican and Thai government debt before the credit markets began to seize up in June 2007.
By bailing out the banks, and other bits of the financial system, the authorities reduce bank default risk but by increasing sovereign default risk. As long as there is sufficient fiscal spare capacity (the technical, economic and political prerequisites are met for raising future taxes and/or cutting future public spending by a sufficient amount to service the additional public debt and maintain long-run government solvency).
One worry about government solvency being compromised by the need to rescue an overly large banking sector.Buiter, unlike Paul Krugman and other prominent US economists, warns that there are indeed limits to how many commitments a a government can take on. Markets can and will exercise discipline (Buiter argues mainly from the UK perspective, but his logic applies to any government):
The key question is, can the government meet all these fiscal commitments, whether firm or flaccid, unconditional or contingent and explicit or implicit ? Does it have the resources, now and in the future, to issue the additional debt required to meet the growing volume of up-front obligations it has taken on?
To be solvent, the face value of the government’s net financial obligations has to be no larger than the present discounted value of current and future primary government surpluses (government surpluses excluding net interest and other investment income)....
In addition to the debt that has been and will be issued to finance asset purchases by the government, there are the future debt issuance associated with the large cyclical and structural government deficits that will be a feature of the coming recession. If GDP falls peak-to-trough by, say 3.5 percent and recovers only slowly, we could have a seven percent of GDP or higher government deficit for 2009 and 2010. Together with the explicit or implicit fiscal commitments made to safeguard the British banking system, the numbers are likely to spook the markets.
With the true net public debt to GDP ratio probably already well above 100 percent of GDP and rising, and with massive public sector deficits, partly cyclical and partly structural, about to materialise, the markets will question the fiscal-financial sustainability of the government’s programme with increasing vehemence. The CDS spreads on UK public debt will start rising. The notion that, except for currency, there may not be a safe sterling-denominated asset may come as a shock. But the same is true in the US. In 2009, the US government will have to sell (gross) at least $ 2 trillion worth of government debt (the sum of the Federal deficit plus asset purchases plus refinancing of maturing debt). The largest such figure ever in the past was $550 billion. In the US too, the markets will have to learn to do without a US dollar financial instrument that is free of default risk.
Buiter's comments on the US raise a second issue: even if investors are not worried about the risk of a sovereign default, there is going to be so much government debt for sale that yields will rise, merely based on supply and demand. We are seeing signs of that now. Consider this warning sign from Germany, the unheard of specter of the failure of a government bond auction of a highly credit-worthy state, via the Financial Times (hat tip readers Chris and Don):
For any government looking to raise money in the capital markets in the next few months, there was an ominous development in Germany this week.
A German 10-year bond auction failed – something more or less unheard of until this year – as cash-strapped banks and investors snubbed the government offering.
It is a clear sign of straitened times when a benchmark bond in one of the most liquid markets in the world cannot attract enough bids to reach its target amount.
Crucially, it raises serious doubts about whether governments can raise the vast amounts of debt needed to fund fiscal stimulus packages and bank recapitalisations in the current tough market conditions.
Any sign of waning demand may force up bond yields – putting further pressure on public finances when they are already under strain.
Nowhere is the issue more pressing than in the US.
Tony Crescenzi, strategist at Miller Tabak, says: “In a world with finite capital and where sovereign nations everywhere are in need of capital to finance their financial and economic stabilisation efforts, the substantial increase in Treasury supply could become manifested in higher long-term interest rates.”
Rick Klingman, managing director at BNP Paribas, adds: “There is no doubt that supply will matter at some point as the financing needs are staggering [in the US]. At the moment, supply is not a large factor with stocks in freefall"....
US Treasury bond supply is expected to hit record levels, in a range from $1,400bn to $1,750bn in the 2009 financial year, starting in October. In Europe, bond supply is forecast to rise to more €1,000bn ($1,247bn) next year – also a record high, according to Barclays Capital.
The extraordinary thing is that, in spite of this huge supply, most analysts expect bond yields will fall. This is because many analysts are now anticipating a deep and protracted global recession, and talk of deflation is even stalking bond markets.
Yields have fallen particularly sharply at the shorter-end of the bond curve, which is most sensitive to interest rate movements, because of the accelerating slowdown in the world’s economies.
Analysts say the economic backdrop is the key determinant of where yields will trade. At the moment equities are so unappealing to investors that bond markets appear more attractive, offsetting supply concerns.
Some government bond yields are also historically low, around levels last seen in 2005, and much lower than in June when inflation concerns dominated trade. For example, German 10-year Bund yields are trading at 3.63 per cent, compared with 4.68 per cent in June.
Riccardo Barbieri, a strategist at Bank of America, says: “In the unlikely event that yields should rise, which I would not expect, they are coming from a fairly low level.”
Germany – in spite of its fourth 10-year Bund failure this year – and the US are likely to be more successful in attracting investors and depressing yields, should the difficult conditions persist, than other countries as they have the most liquid markets and are seen as safe havens...
Another problem for the governments is the competition from banks and financial institutions, which have sovereign guarantees yet offer much higher yields.
For example, this week the UK’s Nationwide priced a three-year deal at close to 100 basis points over gilts.
“The simplistic question is, why buy government paper when you can buy government-backed paper such as this for a much greater return?,” says Sean Shepley, fixed income strategist at Credit Suisse.
With an expected €1,600bn of bank guaranteed issuance in Europe alone next year, this could have a significant impact on investor appetite for government bonds.
Mr Chapman says: “In spite of the prospect of this huge issuance, yields are not being forced higher. This shows just how gloomy people are about the economic outlook.”
Personally, I think investors are so shell-shocked by the crisis that they are only thinking about what to do this quarter, and not about the longer term. Just as during the waning days of the bubble, Citi's Chuck Prince talked of dancing as long as the music was playing, and assuming he and Citi could exit risky positions when the time came, so to many investors may recognize the risk of a rise in government bond yields, but similarly assume they can sell if that comes to pass without taking too much of a loss.
In another, more widely reported sign of stress, the US 30 bond auction this week saw a big drop in demand from central banks, a crucial group of buyers. From Bloomberg:
Treasuries fell, led by 30-year bonds, after investors shunned the government's $10 billion sale of the securities amid concern that U.S. debt sales will grow....
The bond auction followed yesterday's sale of $20 billion in 10-year notes. The $30 billion total of the two auctions is the biggest amount of the securities sold in a week since at least 1990...
``In the current market environment there are still too many unknowns,' said William Larkin, a portfolio manager at Cabot Money Management in Salem, Massachusetts, which manages about $500 million in assets. ``People are looking for the safety of the shorter-term securities.'
Today's bond auction forecast to draw a yield of 4.224 percent, according to the average estimate of seven bond-trading firms surveyed by Bloomberg News. The bid-to-cover ratio, which gauges demand by comparing the number of bids to the amount of securities sold, was 2.07, below the average of 2.19 times in the nine auctions since the bond was revived in 2006.
Indirect bidders, a class of investors that includes foreign central banks, bought 18 percent of the securities offered, down from 43 percent at the last sale.
The skittish may due in part to the G20 meeting this weekend, which could be a negative for the dollar if China's pet theme, the need to move away from the dollar as reserve currency, gets a hearing. The dollar and Treasuries tend to move together. But this is not the first weak Treasury auction we've seen, and if they become more than isolated events, it bodes ill for the strategy many central banks are taking. |
