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Economics Weekly - Fiscal loosening raises risk of country defaults; Weekly economic data preview - Will the Bank of England’s Quarterly Inflation Report pave the way forquantitative easing?

Economics Weekly 9 February 2009


Fiscal loosening raises risk of country defaults


Financial markets are becoming increasingly concerned about the loosening of fiscal policy that is now underway around the world as governments respond to the tumult in credit markets and the onset of recession. Public sector balance sheets globally are taking on some of the debt the private sector can no longer absorb. According to Bloomberg data for instance, in the

period since the credit crisis first broke in 2007, financial institutions have raised $970bn in new capital; of this total, the public sector has contributed $471bn. But in addition to this, with tax revenue falling as economic growth slows and public spending rising as unemployment increases, budget deficits are getting bigger and net debt is rising as a share of gdp. This is the correct response to the crisis and will help foster economic recovery eventually, but the price is that the financial position of many countries is now deteriorating, in some cases quite sharply.


Around the world, governments are borrowing more to offset recession and deal with the credit crisis...

These two trends are illustrated in charts a and b. In chart a, of 28 countries shown, 18 are running net debt positions – in other words, they have more liabilities than financial assets. Of the 10 that are savers, i.e. in financial surplus, at least 2, Iceland and Denmark but especially the former, are likely to be in a net debt position in 2009, with liabilities outweighing assets, as the latter falls and the former rises. According to the latest IMF report, 2009 will see a 1.5% of gdp fiscal stimulus from the top 20 countries in the world. The fiscal easing in the advanced economies is even greater, approaching 7% of their combined gdp. This is the background to the sharp shift that has occurred in credit default swaps for sovereigns in the past year, see chart c. It is a reflection of the fact that financial markets believe that the risk, or likelihood, that a country will default on its bonds has risen sharply. At the time of writing, the CDS rates on 5-year US, UK, German, French and Japanese are all many times higher than they were as recently as August 2008. The chart illustrates that a series of calamitous events in credit markets have precipitated this rise. Chief amongst them was the rescue of Fannie Mae and Freddie Mac, quickly followed by the fall of Lehman Brothers on September 15th and the rescue of Merrill Lynch and Washington Mutual. But these events were not just limited to the US; there were banking bailouts in many other countries around the world.


...this is leading to a sharp rise in CDS rates as the probability of default increases...

All sovereign CDS rates have risen, so this is a global event. But UK and US CDS rates are well above those in Japan or Germany, even though each of these latter countries have bigger outstanding debt than them. The explanation is possibly that the UK and the US may be running bigger fiscal deficits in the next five years. But it could also be reflecting uncertainty about the size of the deficits that the UK and US will end up with. Even so, the long run economic growth potential of the UK and the US is likely to be superior to that of Germany and Japan, even with some reduction in the average rate of growth in the US and UK.


...and a rise in inflation expectations given a higher debt burden

Some argue that CDS rates for sovereigns are misleading because a country that borrows in

its own currency cannot default; since it can simply print more of it to meet its obligations. But printing money to retire existing debt usually leads to significantly higher inflation, so that lenders lose out in real terms. Hence, it may be that the rise in CDS rates is also reflecting this fear - that sovereign debt will be devalued in real terms by inflation. To some extent, this concern is shown by chart e, which suggests that there has been a rise in breakeven inflation rates in these economies, reflecting a higher risk of price inflation. Whatever the reason, however, the rise in CDS rates highlights the perception in financial markets that the probability of default amongst sovereign borrowers has risen. In turn, this implies that the cost of issuing debt by governments around the world is likely to rise in the years ahead. If there is one positive for the UK however, see chart d, it seems to be that its risks are still rated below the average for OECD countries.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview 9 February 2009


Will the Bank of England’s Quarterly Inflation Report pave the way forquantitative easing?


In the wake of last week’s BoE decision to cut Bank rate by 0.5% to 1% as expected, the publication of the Quarterly Inflation Report provides focus on the underlying economic rationale. It may be accompanied by any plans for quantitative easing. GDP growth expectations will be revised downwards, while the BoE has already highlighted a ‘substantial risk’ of a significant undershoot of the CPI target. So we will be looking to see whether or not this report is more pessimistic than in November when for instance inflation was seen to fall sharply back to the 2% target in the second half of 2009 and then towards 1% in 2010. Our view is that there could be at least a few months of falling prices in the UK. Labour market data may add to this concern as the ILO unemployment rate may have risen to 6.4% in December. Key G7 events include the G7 finance ministers’ and central bank Governors’ meeting on the 13-14th, US Fed Chairman Bernanke’s testimony on the Fed lending programme and Treasury Secretary Geithner’s presentation on the TARP. News may also emerge about the passage of the US government’s $820bn fiscal stimulus plan. The Swedish central bank is expected to cut official interest rates by 0.5% to 1.5%.


􀂄 As well as publication of the BoE Quarterly Inflation Report, UK labour market data are due and are likely to raise concern about accelerating job losses. The number of jobless claims is expected to have risen by 90,000 in January bringing the year to date total to 372,300. The ILO unemployment rate is expected to rise to 6.4% of the workforce in December, compared with 6.1% a month earlier. Average earnings growth should stay around 3% on a rolling 3-month basis. Other UK data include the December trade deficit, which is likely to narrow slightly to £8.1bn from £8.3bn in November when it widened unexpectedly as export demand slumped. The RICS house price survey for December and the BRC retail sales survey, showing retailers’ own views of performance on the high street in January, are also published.


􀂄 The US releases its latest external trade accounts - we expect the deficit to narrow to $36bn in December from $40.4bn in November when it shrank at the fastest rate in 12 years on low oil prices and weakening US consumer spending. Other key data include advance retail sales for January, which may have contracted by 0.5%, less than the monthly decline of 2.7% in December, but still amounting to an annual fall of over 10%. Another decline of around 0.8% is expected in business inventories. The preliminary University of Michigan consumer confidence index for February may stabilise around last month’s level of 61. But worryingly, last week’s NFP data showed US job losses accelerating to 598,000 in January, pointing to a worsening in the economy as 2009 gets underway.


􀂄 First estimates of EU-16 Q4 GDP are published on Friday - we expect a deeper contraction of -1.1% compared with a decline of -0.2% in the two previous quarters. EU-16 industrial production is also released and may have fallen by 3% in December as global demand for investment and consumer goods waned. So with the region’s economy well into recession and despite having held interest rates at 2% at its policy meeting last week, we look to see the ECB cut rates by 0.5% to 1.5% in March. The current economic weakness and the fact that the updated ECB forecast for GDP and CPI inflation due next month will be more pessimisic, make it possible that the ECB will cut interest rates again in coming months. Moreover, following discussions at the G7 finance ministers’ meeting at the weekend, quantitative easing may start to be considered as a necessary option for the ECB.

Nichola James, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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