Archive for July, 2016

Concerning Government Debt

With August almost upon us the summer lull is well underway. The FTSE 100 index has drifted along in a 100 point range over the past three weeks; volatility has also fallen away in the US and European stock markets; sterling seems to have found a stable level in the wake of its Brexit-driven devaluation; and yields on the major bond markets, including the gilt market, have found their lows for now. The oil price has fallen back again – the near Brent crude contract has been testing $42 per barrel today, down from over $50 at the start of the month – but aside from that there has been little to report.

There is a chance that could change next week. After the US close today, the European Banking Authority will publish the results of its latest “stress test” for the EU’s largest banks. There has been a lot of focus on the problems in the Italian banking sector: bad loans in Italy have been estimated to amount to 360bn, or about 22% of the country’s GDP. Indeed, when the EBA ran its last test in 2014 the worst-placed institution was found to be Banca Monte dei Paschi di Siena, and an emergency capital raise was required as a result.

This time round statements to the media suggest there are unlikely to be any nasty surprises. European banks have already underperformed the market this year, first of all during the Febrary panic and then in the aftermath of the UK referendum, so a lot of pessimism has been priced in to the sector. And at the stock specific level, the weaker institutions have already suffered severely: BMPS shares have fallen by more than 80% over the past 12 months. Deutsche Bank, another focus for concern, has seen its share price fall by almost 60% over the same period. In fact there may even be value in ending some of the uncertainty in this area. We shall see.

What we know already, however, is that national banking systems rely ultimately on state support in times of crisis. Should there be systemic failure in Italy, or elsewhere, it would fall to national governments to control the damage via bailouts, managed insolvencies with “bad bank” spinoffs and so on. Those governments rely in turn on their sovereign balance sheets. That is better news for some countries than for others: Greece, on the one hand, is in no position to bail out Athenian lenders, while Germany, on the other, could stand credibly behind its banking system if required to do so. So what do those balance sheets look like, compared to the recent past? Which of the world’s largest economies should be able to withstand further shocks to their financial systems, and which of them are probably too deeply indebted to manage it?

Budget Deficit / Surplus % of GDP: pre-crisis, mid-crisis and post-crisis

2006 2009 2015
UK -2.6 -10.3 -4.2
US -1.5 -10.1 -4.2
Japan -1.3 -8.8 -6.7
Eurozone -1.5 -6.3 -2.1
Germany -1.7 -3.2 +0.7
France -2.3 -7.2 -3.5
Italy -3.6 -5.3 -2.6
Greece -5.9 -15.2 -7.2
Brazil -3.6 -3.2 -10.4
India -4.1 -6.0 -4.1
China -0.8 -2.2 -3.4
Russia +7.4 -6.0 -2.9


Gross Government Debt % of GDP: pre-crisis, mid-crisis and post-crisis

2006 2009 2015
UK 42.4 65.7 89.2
US 62.0 85.0 105.2
Japan 177.6 192.9 227.9
Eurozone 67.3 78.3 90.7
Germany 66.3 72.4 71.1
France 64.4 79.0 96.2
Italy 102.6 112.5 132.7
Greece 103.6 126.7 176.9
Brazil 55.5 59.2 66.5
India 60.0 57.3 51.7
China 32.0 36.9 43.9
Russia 7.7 8.3 13.5


This data is sourced from various government agencies and central banks. While there is a certain amount of methodological variety at play the key points are fairly obvious.

Looking at the data on national debt burdens first, it is plain that most developed nations are appallingly badly placed to weather a fiscal storm arising from another financial crisis, or indeed from any other source. The exceptions are (predictably) Germany, and (to a lesser extent) the UK. The one bright spot comes from the bond markets: with interest rates so low in all these nations the burden of servicing their debts is relatively undemanding. In fact Chancellor Hammond may well find he has some limited scope for fiscal loosening come the Autumn Statement if rates stay at their current levels.

Staying in the developed world and turning to the budget deficit data, the eurozone as a whole looks pretty healthy, as does the US. At the national level, however, there are of course some terrible problems. With its shrunken GDP and hefty deficits the burden of Greek debt is now higher than it was prior to the restructuring of 2012. In Italy the budget deficit is actually quite modest now, but that hasn’t helped reduce the country’s debt burden because of its low growth: the Italian economy is 8.5% smaller in real terms than it was in early 2008. This has fed the bad loan problem in the country’s banking system while eroding what ability it has had to manage any serious shock.

Away from Europe, Japan’s balance sheet has exhibited eye-watering deterioration. The postponed sales tax increase there is due next April. This may drive growth down again but it is unlikely to improve the country’s fiscal metrics much. It is true that Japan’s net government debt position is not quite so bad (128% of GDP on the IMF’s estimate for 2015; China’s net sovereign debt position is also greatly reduced at 17%). But with debt at these levels, population decline and (this year) a strong yen the prospects for this quondam global powerhouse remain sclerotic at best.

Brazil, which was downgraded to junk over the period from last September to February by the Big Three rating companies, has suffered economic strife in recent years. Compare its fortunes to those of India, where growth has seen the debt burden shrink even as moderate fiscal deficits have persisted. To end on a positive note it is remarkable how well Russia has managed to cope with the collapse in oil. The days of 7% budget surpluses might be long gone but there is little debt to speak of – and not much of a deficit either.

The numbers here will in many cases take years to improve. In Japan’s case it is not clear how they might be improved at all. Many countries simply cannot afford a national emergency, and will find their fiscal planning easily destabilized by movements in interest rates. Depending on the outcome of the EBA’s analysis tonight there may be one or two European countries very grateful for the backstop represented by the ECB’s ability to intervene in bond markets this weekend.

29/07/2016 at 4:17 pm

A Matter Of Timing

We are now more than half way through 2016. As the year dawned this blog identified monetary policy and the oil price as two of the key things to watch. This week it was the turn of the Bank of England to set tongues wagging on the monetary front; in the meantime the oil price, which has done some central banks such a favour in recent years, has stabilized in the $45-50 range following its strongest quarterly rise for seven years.

The Bank had been expected to cut policy yesterday (from 0.5% to 0.25%). A Brexit loosening to buoy confidence had been the thinking behind this consensus. The MPC, however, held steady. Admittedly the consensus was not especially strong: of the 54 estimates collated by Bloomberg 25 had been for a 25bp cut, 6 for larger cuts and the remaining 23 (who won the bet) for no change. Nor was the defeat especially hard. The MPC announced that “most members of the Committee expect monetary policy to be loosened in August”, further noting that the “precise size and nature of any stimulatory measures will be determined during the August forecast and Inflation Report round.”

If, in the words of one senior figure on Threadneedle Street, the British economy needs a post-referendum “sledgehammer” (not an obvious choice of metaphor for a stimulus but one catches his drift), then why delay? If the Bank is to bolster confidence why didn’t it just get on with it? What sort of doctor decides that his patient, suffering some obvious ailment, could really do with a shot in the arm – but then decide to wait another month before administering it?

On the other hand, as that senior figure – MPC member Andy Haldane, the Bank’s chief economist – further put it, while there is some evidence of weakness in hiring and investment: “There is no sense of slash and burn. But there is a strong sense of trim and singe.”

In any event the point is that we do not yet know what the impact of the Brexit vote has been. There is anecdotal evidence from the property market, for instance. But it won’t be until at least early August that we have much actual data to look at.

There is an irregular exception which we ought to deal with quickly. GfK, who produce the UK consumer confidence series, undertook a one-off bonus survey in the aftermath of the referendum. (Their regular end-June number was based on surveys conducted during the first two weeks of the month.) Published last Friday this showed a fall in the index from -1 to -9, the biggest monthly decline since December 1994. On the other hand, the index has averaged precisely -9 over the last 30 years, peaked at only +7 in mid-2015 and went as low as -39 at the nadir of the Great Recession.

One thing we do know for a fact, however, is that the pound is 7% weaker, trade weighted, than it was when the last Inflation Report was published in May. It is down 11.5% in 2016 to date and has fallen 13% since its peak just under one year ago. Currency weakness is itself a form of monetary loosening which translates into imported inflation, higher exports and (not allowing for Brexit fears) greater inward investment. Is a cut of 25bp on the base rate really required as well? Particularly as the urgency of such a move is clearly not great enough to obviate the delay associated with data releases as well as the elegance of wanting to time MPC action to coincide with the publication of the Bank’s own detailed economic and monetary analysis?

And so back to oil. This is now back at exactly the level it settled at for a few months from last August. Very soon, then, the deflationary effect it has over the previous year will reduce to about zero. In February the Bank put the contribution of cheap oil to annual CPI at -0.4% through direct effects alone. That is quite a lot of disinflation to be giving up. The next RPI and CPI prints come out on Monday, with figures for July only arriving until after the next MPC meeting. So they may not be sufficient to challenge what will doubtless be a 100% consensus, backed by the MPC’s own words, for a 25bp cut next time. But the direction of travel is clear.

There is also the labour market to consider: 186,000 jobs were created during the first quarter of this year, and the ILO unemployment rate at 5% is only 0.3% off its 2004 low. Brexit risks may argue for a rate cut (though again, on that basis: why wait?) But the pound, the oil price and the labour market argue at least for staying put in August too.

The complication for investors here is that markets were already mildly disappointed with the Bank’s failure to cut yesterday. Put it off again, or postpone it indefinitely, and their disappointment may lose that mildness.

There is another possibility to consider: that Brexit fears might recede in coming months. What then for prices? And for monetary policy? And for bond markets, with the UK base rate not priced to rise above its current level until the end of 2020?

As so often our central bank finds itself in a bit of a spot. Nervousness pushes its hand one way; known fundamentals to date, at least, another. If the data which comes out between now and the next MPC meeting is unhelpful to the consensus the Bank can either act inappropriately or spook the market. If the data is poor, and so helps the post-referendum blues argument, then that is bad news for the economy.

Whatever the longer-term consequences of Brexit for the UK the shorter term prognosis for assets of certain types does not look rosy.


15/07/2016 at 4:10 pm

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