BATTLE LOOMS BETWEEN CREDITORS AND BORROWERS / THE FINANCIAL TIMES ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Battles loom between creditors and borrowers

By Richard Milne

Published: January 3 2011 18:11

‘Everyone has to bear the great burden’ of debt and taxes, warns a French engraving circa 1789. Now, 222 years on, concern at the level and sustainability of borrowings is prompting authorities across the west to impose harsh measures

A few weeks ago, a large US investment bank asked a discreet question of its biggest institutional investor clients. How long would it be before the debt crisis that has struck Europe reached the US? One, two or three years, or never? “Under 10 per cent said never,” says a banker involved in the polling.

Last year brought the eurozone debt crisis. Greece and Ireland had to be bailed out and big question marks still hang over Portugal and Spain. But the focus is now likely to widen. The question for 2011 is how much of the western world could be caught up.

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“It is definitely looking more systemic,” says Kenneth Rogoff, a Harvard professor who was formerly chief economist at the International Monetary Fund. “Whenever there is a wave of banking crises, a wave of sovereign debt crises follows a few years later.”

For many, the focus on government debt merely represents the latest act in a sprawling drama that ensnared emerging markets at the end of the last century and has since moved on to developed nations. It culminated with the bursting of the credit bubble three years ago in an event that both ended the debt-fuelled housing boom and sparked the financial crisis.

“Over the past 10 years we have had the serial contamination of balance sheets. First households, then banks, then the private sector and now governments,” says Mohamed El-Erian, chief executive of Pimco, one of the largest bond investors in the world.

Continental Europe is seen as most immediately at risk – and it is likely to become clear in 2011 whether the problem can be contained or will spread to engulf the eurozone’s bigger members. Few see an imminent risk for the US, Britain or Japan because their problems are less acute and they retain national central banks that are able to start up the monetary printing presses. But some investors are beginning to fret about the level and sustainability of debt across the west.

It is all fuelling talk of an impending tussle between global creditors and debtors, with big implications for the most indebted countries. “We will get these battles between creditors and debtors,” says Matt King, head of credit strategy at Citigroup.

For now, the focus is on Europe and whether contagion can be stopped before Spain is infected. The next few months are likely to prove vital. Governments across the eurozone have to raise billions of euros; companies from so-called peripheral eurozone countries including Greece, Ireland, Portugal and Spain have similar needs.

Steven Major, head of fixed income research at HSBC, says this is likely to put pressure on every auction of government debt in 2011. The risk is that if Spain is not protected, bigger nations are next in line.

“Spanish government auctions will be a major focus in the first quarter. It is important that the contagion stops with Portugal, Ireland and Greece,” he says.
Underpinning this concern have been analyses of the total level of debt in countries, including the private sector.

Once interest rates have risen for governments, the worry of many in the markets is that banks and other companies could also find it hard to borrow.

Mr King argues that the sheer level of debt lies behind much of the current uncertainty in the world economy and markets – and that the paucity of assets that some countries and companies hold means they could be facing a “balance sheet recession”.

His look at non-financial debt alongside that of governments has some surprising outcomes. Countries with well-known large levels of national debt to gross domestic product – including Japan and Italy – come out of it fairly well, because their private sectors are net savers. But a country such as Spain, with relatively low government borrowings, fares poorly because of the enormous amount of debt held by companies and households.

With banks having loaded up on government debt, prompted by capital regulations, any problems would have far-reaching consequences. “It’s about people’s attitude to risk. The world becomes very sensitive to changes in the perceived riskiness of things, in particular government debt,” he says.

Jim Reid, his counterpart at Deutsche Bank, uses the experience of Ireland to argue that looking at government and financial debt combined is important given how systemically important the banking system has become in each country. That leads him to find that debt-to-GDP levels in the US, UK, core Europe and peripheral Europe are all at 150-200 per cent, higher than at any time in the past 15 years and possibly the past century.

He now believes the series of rolling debt crises we are seeing will lead investors to revert back to how they behaved before the leveraged boom and be far more discerning in whom they lend to.

“At the edge of the financial market there are a lot of entities that borrowed money that wouldn’t have been able to before and probably won’t be able to again,” he says.

That suggests problems for countries such as Greece and Portugal and many companies and banks. “You reach a point where the private sector is just shut out,” says Prof Rogoff.
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How big could the problem become? Prof Rogoff, along with Carmen Reinhart of the University of Maryland, has done research that suggests that a country’s growth potential slows significantly once its debt-to-GDP ratio goes above 90 per cent.

The US is currently at about 93 per cent.
But most economists have just raised their targets for US growth this year to about 3-3.5 per cent, following the Federal Reserve’s latest bout of quantitative easing. Indeed, rising growth expectations rather than the souring fiscal outlook was the main explanation for a recent spike in the yields of 10-year Treasury bonds, the market interest rates for the US.

Prof Rogoff is adamant that in spite of its debt burden America will not get caught up in the current sovereign crisis. “The US has crossed [the 90 per cent] threshold and that will weigh on growth. But I don’t think this round will hit the big countries. They have a lot of cards to play.”

One big differentiating factor is sovereignty. As Mr Major underlines, the US, UK and Japan all have control over fiscal and monetary authorities, allowing them to use quantitative easing – where central banks purchase government bonds – to buy all the debt they issue if necessary. The eurozone, with the European Central Bank unwilling to engage in full quantitative easing, is more constrained.

Pimco’s Mr El-Erian says that psychological factors are also at play because of history.

The US is scared of recession, whereas Europe is more worried about inflation than a downturn. The possibility of a rise in interest rates seems to some central bank observers more likely in Europe before the US. Mr El-Erian thinks that means any pain will be “predominantly in Europe” but is also possible in the “lower levels” of municipal government in the US.

“If you look to the next five years you will get a repeat in developed countries of what you got in developing countries in the 1980s and 1990s. You will see a set of countries that will not be able to deal with their debt overhang without restructuring. Is it pre-emptive or will it happen like Argentina?” he asks, with reference to the decision by Buenos Aires to default on part of its foreign debt in 2002, one of the biggest sovereign restructurings in recent times.

Like many in the market, Mr El-Erian sees it as all but inevitable that at least some of the peripheral eurozone countries will have to restructure their debt – a polite equivalent to default – in order to reduce their debt burden. That might not come this year but most market participants expect it by 2013 at the latest.

The recent sharp rise in yields for the US and other western countries could even speed up the process, if past crises are anything to go by. Prof Rogoff points to both the Latin American crises of the 1980s and 1990s and the Asian crisis of 1997 as having been aggravated by rising US rates.

The danger with a European restructuring is that if it is a messy process, as in Argentina at the start of the century, other nations could become swept along in the contagion. That would lead, according to Mr El-Erian, not just to a decline in risk appetite among investors but also to concerns about further countries with high debt burdens. Emerging markets could suffer too.

Mr King says, “Whether you get a problem largely depends on confidence. That is why the situation in the US is more fragile if Europe blows up again.”
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Most market participants believe the authorities would not let developments reach such a dire stage. Certainly, they remain worried about Europe, where a game of chicken between Germany and the ECB as to who protects the system complicates matters. But as Paul Marson, chief investment officer of Lombard Odier, a private bank, says: “If you rescue Bank of America, you will rescue California.

If you rescue Ireland, you will rescue Spain.”

Rescue or not, the broader philosophical question remains about the nature of the financial system. If skirmishes between creditors and debtors worldwide erupt into full-fledged war, the debt-fuelled growth of the past few decades would halt for the duration. Creditors would then balk at providing money to countries whose debt burdens were worsening. But debtors could also become fed up with responding to creditors’ desire for austerity, as peripheral eurozone countries might still end up showing Germany.

Mr El-Erian sums up the problems: “One is that creditors become less willing to kick the can down the road. The second is that debtors get adjustment fatigue.”

Either way, the result is stalemate. The relationship between China and the US, perhaps the archetypal creditor/debtor set-up, is frequently summed up as being a “prisoner’s dilemma” where neither side can exit the arrangement without causing considerable damage to both. How that situation plays out will have a great impact on the fate of indebted western countries everywhere.

Mr King thinks not only debtors will suffer pain: “The long-term resolution will almost certainly be a big transfer of wealth from creditors to debtors. As much as Germany and China try to inflict pain on debtor countries, they will then default on you, or there will be QE4 or 5.”

The problems around sovereign debt look less and less limited to single countries such as Greece. But equally, a full-blown crisis that draws in the US seems unlikely. Thanks to low interest rates and QE2, the authorities appear to have staved off the possibility of a double-dip recession and created another debt-fuelled cycle. But, for Mr El-Erian and others, that might just have delayed the day of reckoning.

“Kicking the can down the road only works for so long. You kick it less distance each time. And then things become unstable.”

Burden on banks

In “peripheral” eurozone countries, not only national treasuries face a difficult 2011. Companies and banks in Greece, Ireland, Portugal, Spain and Italy also have huge refinancing needs. Of the €1,300bn ($1,734bn) of bank debt that is estimated to need refinancing in the next three years, €700bn will come from banks in those nations, according to Deutsche Bank. Italy and Spain dominate, with about €280bn each. Deutsche highlights five banks with the highest proportion of debt maturing in the next three years: Greece’s Piraeus Bank and EFG Eurobank, Anglo Irish Bank, Italy’s Cassa Depositi & Prestiti, and Spain’s Bankinter.


.Copyright The Financial Times Limited 2011