This article is a guest contribution from James Pressler, Northern Trust.
As we take stock of the global landscape at mid-year it is immediately apparent that international risk appetite remains very fragile, with bond market investors in particular nervous about the massive amounts of debt being issued by many countries. Fear of sovereign default (historically a pretty rare occurrence) has surged. For many countries credit default swaps (CDS), the main point of reference for indicators of sovereign default risk, remain sharply higher than two years ago (Chart 1). The synchronized nature of the global financial crisis and recession led to a massive increase in government borrowing that has yet to abate. Most investors are reluctant to take big positions given the level of uncertainty about the global outlook and even emerging market debt issuance has been drying up in recent weeks as spreads have ballooned. After last year’s recession-induced fiscal blowouts, many sovereign debt issuers are now discovering that demand at auctions is hinging on domestic policy news, particularly on progress in implementing fiscal tightening or even outright austerity. The need to keep the bond market happy while implementing often far-reaching fiscal reforms is most acute across Europe, where the outlook is for weak real GDP growth into 2011 – albeit with significant variations between countries. Conversely, the recoveries in Asia and in the Americas have effectively eliminated fears of sovereign defaults but now concerns over economic overheating will dominate. Finally, the U.S will eventually have to address its own public debt overhang, but for now is enjoying a temporary safe haven status.
Chart 1
Europe: Higher Funding Costs and Painful Reforms
The trigger for Europe’s current difficulties came late last year with revelations that Greece’s budget deficit and public sector debt levels were far higher than previously admitted. As a result Greece, with junk-level sovereign debt ratings and punishingly-high CDS rates (Chart 2), is now shut out of the markets and dependent on IMF and EU aid. However, the roots of Europe’s woes can be traced to last year’s recession. The economic contraction hit some public budgets harder than others, depending on the underlying flexibility of labor markets, the fiscal stimulus measures enacted, and the level of spending on banking sector bailouts. In the wake of a number of Euro-zone sovereign debt rating downgrades earlier this year, the markets are now hyper-sensitive to the longer-term fiscal outlook across the region. Euro-zone sovereigns face additional pressure because they are unable to print money to repay their outstanding debts. Non-Euro-zone Sweden, which has recovered smartly from the recession, looks set to return to a public sector surplus by 2012 without having to implement any major spending cuts or reforms. The rest of the region is not in such a happy place. Countries such as Finland and Germany should be able to get their government accounts back onto a sustainable path by clawing back stimulus measures and continuing with existing plans to maintain competitiveness and productivity – although the political fallout of spending cuts will mean headaches for the incumbent governments. However, countries such as Spain and Portugal will need more deep-seated structural reforms of their labor markets and public spending. So, too, will France and Italy, although they are not yet as afraid of the bond markets, being much bigger economies and able to carry a higher debt load.
