Yesterday I attended a lunch with two senior IMF officials (hosted by Morgan Stanley), which came on the back of a number of excellent recent publications from the Fund (the speakers drew heavily from the Global Financial Stability Report, but it’s also worth having a look at the World Economic Outlook and Fiscal Monitor).
Financial stability has generally improved over the last half year, but numerous vulnerabilities and challenges remain. The biggest medium term risk for developed countries was deemed to be the fiscal situation in the US and Japan. The US in particular is showing little appetite to reduce fiscal deficits or government debt levels. US gross government debt levels are approaching a concerning 100%, about 43% of what the US government spends is financed by borrowing, and yet the political parties are struggling to agree on the right course of government action. Special interest groups are having more and more political power, making it harder to increase taxes or reduce government spending. A build up in public debt means that the US and Japan are becoming increasingly vulnerable to a rate shock, with the US having an average debt funding cost approaching 10% of tax revenue, a level that Moody’s have previously suggested puts the US credit rating at risk. As debt levels increase, the danger is that it requires a smaller and smaller increase in bond yields before debt interest costs hit 20% of tax revenues (in the US this is when the average borrowing cost is above 6%, but in Japan this has fallen to a little over 4%). The US is driving closer and closer to the cliff edge, testing when investor confidence is going to break.
One of the biggest short terms risks is unsurprisingly the Eurozone debt crisis, where funding costs need to be reduced and more clarity needed on EFSF/ESM support and the debt restructuring mechanism. This is especially urgent given that the political will for further austerity and bailouts is likely to wane, with current elections in Finland an interesting barometer. In terms of the likelihood of sovereign debt restructuring, an interesting discussion point around the table was that if the market starts to view Spain as ‘safe’ and Spanish sovereign spreads tighten, then the likelihood of a sovereign restructuring at some stage in Greece actually increases since the authorities would deem it very unlikely that a Greek restructuring would result in a European ‘Lehmans event’. However, if Spanish sovereign creditworthiness comes under pressure, then the likelihood of a Greek restructuring taking place would most likely fall, since the risk of contagion from a Greek restructuring to other sovereigns would be seen as too great.
It’s not just the governments that are struggling to reduce leverage. Households need to reduce debt too, with mortgage debt forming 75% of US household debt, and US household debt is already 91% of US GDP (the UK’s household debt is in fact higher still, at 107% of UK GDP). More principal writedowns by banks are needed, and the large debt overhang poses further downside risks to housing markets.
Finally, in terms of emerging markets, capital flows have accelerated and this is causing policy dilemmas for a number of emerging market countries. Some nations (namely China, India and Turkey, but also some countries in Latin America) are experiencing worrying private credit growth rates, and authorities need to allow their currencies to appreciate to prevent overheating and the build-up of financial imbalances. While emerging markets do not look like they’re about to pop, there are warning signs of bubbles developing.