Wednesday, November 10, 2010

Debt and democracy

Debt and democracy....
By Chan Akya,464/

A full-scale revolt appears on the cards between the demands of markets and those of citizens facing either austerity or spiraling deficits in developed democracies. Creditors may well start preferring the debt issued by dictatorships to that issued by democracies as a simple means of avoiding uncertainty.

Central banks are confusing the picture further for markets, as are the increasingly shrill comments from multilateral agencies and some creditors. All of that's not good news for potential growth in coming years, and perhaps even clouds the outlook for democracy itself.

Debt and democracy
Many years ago, when I was a rookie looking at the debt of emerging market countries, a senior chap took me aside and confided in his versions of a "trade secret" - namely to always avoid the debt issued by democracies. Of course, the person providing me with these nuggets was himself from a Western democracy, but that didn't quite cloud his view of how poorer countries should be run.

The "logic" was as follows: democracies tend to be messy, and new governments may change agreements that were painstakingly put in place with any other government. In contrast, dictatorships were fairly dependable - any internal opposition would of course disappear, and all external contracts would be honored because "after all, that's where the money is coming to these guys from".

This "mentor" even showed me a fancy graph to prove his point; but the main point that came through loud and clear from that meeting was that the concept of democracy was simply inapplicable, or at the very least detrimental, to the way poor countries with a lot of debt could be run. As I don't have the graph at hand now, two from Bloomberg this week help to illustrate the point. The first highlights the credit default swap (CDS) levels of five-year debt issued by various European democracies:

Contrast this with the CDS of various non-democratic societies, for example China, Russia and Saudi Arabia as in the following graph, also from Bloomberg:

So my "guru" was right after all - democracies do perform worse than dictatorships, at least in terms of debt markets. [1] Of course, I have my tongue firmly in cheek here, for among many other reasons I have taken non-representative samples of both ends of the spectrum (democracies and dictatorships).

However, it bears noting that general averages of credit default swaps (so-called CDS Indices) are not far away in making the same point about the elevated risk of European sovereigns relative to companies domiciled in Europe as well as the general risk of countries situated on the periphery of Europe (in the graph below, marked as CEEMEA, or Central and Eastern Europe, Middle East and Africa).

The interesting thing about this graph is of course that after tracking each other for a long period of time, since June this year the cost of insuring European companies and high-risk emerging sovereigns has gone down steadily while the equivalent cost of insuring the debt issued by wealthy, developed countries (the white line) has gone up steadily.

Talk about decoupling.

The simplest explanation for this dichotomy is provided in the following chart, produced by the International Monetary Fund (IMF) and carried by a number of publications including the Wall Street Journal last week; this details the biggest borrowing relative to gross domestic product (GDP) by various developed countries, all of which add up to a truly staggering figure of US$10.2 trillion in borrowings next year. It is worth pointing out that the only country seeing any marked decline in its borrowing relative to GDP is Ireland, which implemented a dramatic austerity plan to cut government expenditure.

If you were the finance minister of a country that had massive borrowing requirements for the next couple of years and your CDS was blowing out, what really are the choices you'd look to embrace? What would you tell the citizens of your country about the situation? What, more importantly, would you expect your citizens to be signaling to you?

So it was with some sense of irony that I watched the events of the past few weeks unfolding across Western democracies. Notable ones included:
a. Last week's vote against President Barack Obama's policies in the United States with a triumphant return for the Republicans to the scene of their last crime, namely the US financial crisis of 2008.
b. Germany's insistence on new policies across the European zone that would force investors in European debt to share the pain of any default rather than blithely expect (or secure) a simple bailout.
c. Strikes in France paralyzed the country for a few days over the past few weeks but worse appears to be on the horizon across transport, government and banking sectors.
d. While the United Kingdom's austerity drive appears to be proceeding with less drama than others, there were some strikes on the London underground network last week, causing billions of pounds of losses to an already frail economy.
e. Greece witnessed an increase in anti-government protests, with extremists mailing a bunch of letter bombs to the heads of various European countries as well as a number of embassies and consulates in Athens.

Meanwhile, central banks have jumped in apparently to defend some sort of a status quo in their backyards:
1. The US Federal Reserve announced a plan to purchase $600 billion in bonds as part of further quantitative easing (see The Incorrigibles, Asia Times Online, October 16, 2010).
2. The European Central Bank left rates on hold while reiterating its preference for European governments to work closely together while implementing a more realistic fiscal austerity plan.
3. The Bank of England, while leaving rates on hold, warned of an "extended period of inflation", in effect signaling its willingness to allow negative real interest rates to take hold of the UK economy.
4. After running out of all other types of assets to purchase, including government bonds, the Bank of Japan has now started purchasing Japanese stocks, particularly real estate investment trusts even as it tries to push the yen lower against major currencies.
5. The central banks of Australia and India raised interest rates during the week, worried about the effects of imported inflation on their economies and political systems.

Central banks and their idiotic policies are however not the subject of this article - I will write at length about their shenanigans at another time. In any event, and just to make things really interesting, externalities have gone out of control:
a. Germany criticized the "clueless" policies of the US in trying to pump prime the economy, with a focus on fiscal austerity that would render Ludwig von Mises proud.
b. China is set for a showdown against the US at this week's Group of 20 meeting over a plan to implement numerical limits on deficits / surpluses even as its central bank has issued a bunch of statements condemning QE2.
c. The head of the World Bank has asked for renewed discussion on a re-introduction of a gold standard, updated to reflect the requirements of today's global economy.

All of this sets the stage for what happens in democracies that are inhibited by high debt loads around the world.

Exhibit A - Obama is rejected
The sheer scale of popular revolts against governments across the developed world over the past few weeks is the main subject of this article. In this regard, Exhibit A would be the popular rejection of President Obama's policies by US voters.

His Democratic party was thrashed at the polls by the Republicans, who took control of the House of Representatives by a significant margin, even as the senate remained barely under the control of the Democrats. If one followed US media on the subject, it appears that the rejection was all about the presidential failures in stimulating the economy, spending too much on pork-barrel projects and protecting people who didn't deserve his protection (ie bankers).

That said, it is difficult to figure out what exactly the opposition that unseated Obama's political party actually stands for. The common refrain is that "deficits must be controlled", although a simple math lesson would tell you that a deficit is simply the result of excess spending relative to revenues. Given that the Republicans would never consider revenue increases (ie tax-rate hikes) to even be remotely acceptable, what then are the options in terms of cutting expenditure?

This is where the tire meets the road, in a manner of speaking. I would be terribly interested to see politicians in the middle of a recession arguing about ways to impose austerity on the populace and in particular to cut the entitlements of millions of people for the greater social good. Just to avoid any doubts on the subject, the statement above implies that I do not expect any such outcome - that is, to see the Republicans willingly shoot themselves by proposing or pushing through effective austerity measures.

That view in turn brings us back to the question of what all the drama was really about, ie change for the sake of change rather than anything substantive. If voters were less emotional, they would look at the failure of supervision that was central to the Federal Reserve's mishandling of the financial sector since 2000 aided and abetted by the Republican leadership of the time. In turn, this caused multiple episodes of predatory lending and over-eager expansion of leverage across the financial system.

If the opposition is in a mess, the president's own party doesn't appear to have a clue about what it wants or indeed has learnt from the election debacle. A number of suggestions are being made - from the left, Nobel economics laureate and New York Times columnist Paul Krugman and company accuse the president of losing the elections because of not being left-leaning enough, that is, not proposing more government intervention than he already has. Others in the party blame the defeat on the president's failure to be sufficiently centrist.

What all of this means to an external investor in US government debt is of course confusion on a grand scale. There is no clear way forward in terms of government policy; and while it cannot be reasonably said that Obama is a "lame duck", such a suggestion doesn't appear completely unreasonable either.

The only certainty from that observation would therefore be the policy uncertainty of the kind my "guru" warned me about in respect to investments in emerging markets, referred to at the start of this article. The simple fact that political fissures are deepening across various countries so early into the aftermath of a financial crisis suggests that the path forward is likely to be paved with obstacles for all democracies, not to mention increasingly knee-jerk reactions from debt markets until the outlook for growth stabilizes.

1. Credit default swaps (CDS) are quoted as basis points where 100 basis points is equal to 1%; as with bond yields, the bigger the number the worse the supposed quality of the referenced issuer. Thus when CDS levels increase, the general comment is that insurance has become more expensive, ie that the referenced entity is being perceived as more risky by the markets.

No comments:

Post a Comment