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SectionsDecember 23 2009

Cleaning up sovereign debt

The US and European governments have so far managed to maintain investor appetite for greatly increased issuance of public debt. But decisive action will be needed to avoid paying a high price in the near future. Writer Philip Alexander
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Cleaning up sovereign debt

When ratings agency Fitch downgraded Greece’s sovereign rating to BBB+ from A- in December 2009, the resulting 130 basis points widening in spreads on Greek government bonds served a jarring indication of the longer-term consequences of the 2008 financial crisis. Bank balance sheets have been saved – but at the expense of a rapid deterioration in public sector balance sheets.

Sovereign debt issuance rose by about one-third in 2009 and has not peaked yet. At least another 10% rise is expected in 2010, taking the total new supply to the market to about $1100bn. The greater government demand for funding in the capital markets puts the squeeze on other borrowers. “Interest rates are low today, but we estimate that when the private sector recovers, the absence of any public debt reduction would add two percentage points to interest rates worldwide,” says Carlo Cottarelli, director of the International Monetary Fund’s (IMF’s) fiscal affairs department.

Each market participant has their own views on which sovereigns should be prompting the most concern. One senior fixed-income strategist draws a distinction between “structurally challenged” and “cyclically blessed” sovereigns. By this, he means we should be more worried about countries that have high structural fiscal deficits (stripping out the effects of the economic cycle) and relied-on consumer debt build-ups to fuel economic growth. The UK is a clear example of this, with a structural budget deficit in excess of 10% and a household debt burden that is still unwinding.

By contrast, the aggregate eurozone structural budget deficit is 2.8% because countries such as Germany and France will see deficits tighten significantly when growth resumes. And their growth is driven more by exports, reducing the need for household deleveraging.

However, Justin Excell, the head of rates for reinsurance giant Swiss Re, says the weaker eurozone states such as Greece, Portugal, Spain and Ireland carry risks distinct from those in the UK or the US, which both have sovereign central banks that could ultimately print money to support debt-payment capacity. “We believe the eurozone would help Greece out of a sticky situation, but it is not guaranteed, especially as it would create moral hazard by discouraging other governments from taking tough fiscal measures. This is the same dilemma as with Lehman Brothers – the risk of moral hazard, or the risk of a domino effect if one sovereign went down,” says Mr Excell.

Ben Davey, the co-head of financial institutions at Rothschild, who has handled many sovereign advisory mandates, sees profound global changes in sovereign financing, typified by China’s recent issue of a debut 50-year renminbi bond. “There are only a handful of sovereigns worldwide that have managed to issue 50-year bonds, so the whole sovereign finance market is reshaping itself – acknowledging that the world order has gradually moved, and re-evaluating long versus short-term credit,” says Mr Davey.

Withdrawing support

The downgrade of Greece triggered a particularly strong market reaction because it heightened the possibility (flagged in The Banker in February 2009) that the country’s sovereign debt would one day no longer be rated highly enough to qualify as collateral for bank repo transactions with the European Central Bank (ECB). The ECB normally only accepts collateral that has at least one rating of A- or above from a major credit rating agency. It lowered this threshold three notches to BBB- to combat the crisis. But only until the end of 2010.

This is a stark reminder that 2010 is the year when emergency measures by central banks to support financial markets are due to be unwound, which is prompting even more uncertainty in sovereign debt markets. Tim Adams, who was under-secretary at the US Treasury from 2005 to 2007, represented the US at the G-20 economic discussions during that time and is not convinced by their pronouncements today.

“For all the rhetoric in the G-20 about co-operation on exit strategies, I think there will be very little. Each government will pursue the fiscal and monetary policies on a time horizon that suits their own interests. It also looks like there could be some struggles between fiscal authorities and central banks in certain countries, so 2010 could be a turbulent year,” says Mr Adams.

Investors harbour particular concern about the end of quantitative easing in the UK. The Bank of England has been releasing cash liquidity into the banking system by buying commercial banks’ holdings of UK government gilts. One analyst calculates that this has soaked up the equivalent of more than 100% of new government debt issued since March 2009, but the extraordinary purchases are due to end in the first quarter of 2010.

A further source of uncertainty is the response of investors to moves in exchange rates, especially the weakening of the dollar and sterling against the euro. The dollar remains the dominant international reserve currency, with the result that central banks worldwide have huge holdings of US treasuries, especially at the short end of the maturity curve.

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Myles Clarke, joint global head of the frequent borrowers group at royal Bank of Scotland

Mr Adams, who is now a partner at The Lindsey Group advising major investors on global economic trends, says Asian central banks continue to seek ways to reduce their vast exposure to US treasuries. But they recognise that it is “a long process. They are operating in a fish bowl and any indications that they are trying to dump dollars would be very destabilising. So they are in a bit of a box, trying to get out by shortening duration and trying to stop accumulating reserves on the same scale in the first place,” he says.

By contrast, as sterling is not a core reserve currency, analysts are wary of how overseas investors – mainly central banks – will react if weak economic fundamentals continue to put pressure on the exchange rate and fiscal indicators (see chart, previous page). “Overseas investors have been the most important marginal consumer of UK debt, accounting for about 35% of the total gilt stock in the first quarter of 2009, which is almost a doubling in the past decade. We do not expect that trend to continue,” says one fixed-income strategist.

Inflation-linked debt

As central banks pull back from their implicit support for public-bond issuance, debt management agencies will need to be increasingly nimble and innovative to maintain appetite in the financial markets without paying significantly increased interest costs. That said, debt capital markets bankers are divided on whether conditions for sovereign borrowers will improve in 2010, or remain volatile.

“Government-guaranteed bank issuance was a huge pool of funding that needed to be done, somewhere around E750bn, but has now nearly disappeared completely, dropping to about E50bn next year. So the deficit situation is a problem in specific cases, but if you take it altogether, the dynamic is not as intimidating as the massive uncertainty that we faced in January 2009,” says Myles Clarke, joint global head of the frequent borrowers group at Royal Bank of Scotland.

However, Bill Northfield, head of sovereign, supranational and agency originations at Deutsche Bank in London, says sovereigns may face different headwinds in 2010. “For much of 2009, covered bond issuance was limited and bank issuance was concentrated in the shorter tenors, leaving sovereigns to fund in the five-year and longer part of the curve, with limited competition. As the credit markets started to unlock after mid-2009, our corporate syndicate desk in London began doing two or three deals most days. If this continues next year, sovereigns will be fighting for profile in a crowded market,” he says.

The inflation-linked arena is one in which sovereigns have so far been able to raise funds virtually unchallenged by corporate debt and the consensus is that this will form an important part of diversifying and maintaining the investor base. Regulatory changes spreading out across Europe are encouraging greater liability-driven investment, with institutional investors encouraged to match their assets to liabilities that rise with inflation.

Mr Excell says that UK linker gilts or US Treasury inflation-protected securities are more important for his portfolio than eurozone linkers, because many eurozone reinsurance premiums have an inflation-uplift clause set into the contract in any case.

“We not only look at what proportion of our liabilities has inflation exposure, but we also underweight or overweight linkers based on our view of where inflation is headed,” says Mr Excell. In the eurozone, only Italy issued a linker in 2009, as inflation remains low. But given the scale of monetary easing, that benign inflation environment seems likely to change once economic recovery sets in, whetting investor appetite for linkers.

Inflation-linked assets have other advantages for the liability management profile of the sovereign issuer itself. “There has been quite a lot of short-end issuance in 2009, so there is a natural inclination for issuers to term out their debt and inflation-linked naturally does that for you. A 15-year linker might have a duration profile similar to a 25-year conventional bond, because the repayment profile is back-ended – linkers typically redeem at more than 100, since the principal is linked to inflation,” says Mr Clarke.

Adapting issuance techniques

The bulk of issuance will remain conventional, un-indexed bonds and there were already some important new developments on these in 2009, as debt management agencies adjusted to the sharply increased pipeline. To complement the process of a steady auction calendar to the 16 primary dealer banks who sell on to end-investors, the UK undertook its first syndicated conventional gilt issue in June 2009. This was a 25-year bond which, at £7bn ($11.4bn), was also the largest-ever syndicated sovereign issue.

“The investor base is similar, but it is a more direct way of engaging those investors appropriate for long-dated trades. It is a way of drawing the end-investor closer to the discussion about quantity and pricing, which is more relevant in the longer end where liquidity is less and the size of individual investor tickets is greater,” says Mr Clarke of RBS, which was one of the bookrunners on the deal.

To keep profile and appeal among investors in 2010, Mr Northfield believes that sovereigns will need to be flexible on maturities and to develop their yield curve. In 2009, most sovereign financing was towards shorter maturities, based on programmes pre-announced at the height of market volatility in December 2008.

“I would not be surprised if, in 2010, more sovereigns adjusted their programmes on a quarterly basis to suit prevailing market conditions and more focused on renewed issuance in the 15 to 30-year part of the curve, to lock in long-term rates in a currently low-inflation environment,” says Mr Northfield.

Fiscal competition

Increasingly, there are signs that sovereigns will be competing directly on the strength of their fiscal turnaround stories. In the final weeks of 2009, Greek bonds came under pressure until the country’s government began to set out retrenchment plans capable of reassuring investors. Meanwhile, Ireland’s sharp spending cuts and comprehensive ‘bad bank’, National Asset Management Agency (NAMA; see Ireland story, page 36), partially protected its sovereign bond spreads from market contagion.

Mr Davey at Rothschild advised the Hungarian government on investor relations following its IMF emergency lending package in 2008 and is now also working with the Irish government on its banking sector. “For Hungary, we helped take their plan and put some international metrics around how well they had delivered on it and how that would benchmark against other international economies if they continued to deliver. The minister of finance then put that message to the market,” says Mr Davey.

Mr Excell, who helps manage a portfolio worth about SFr70bn ($67.5bn) in high-grade government debt and inflation products at Swiss Re, emphasises that widening spreads can present investment opportunities if the ­government has a credible plan. “We look for definitive signals for action from countries we hold or would potentially invest in. If the premium offered by the market appears to exceed the risk, then it may be the right moment to diversify into that sovereign,” he says.

Taxing questions

Raising taxes will clearly be part of the route back to budget sustainability, but here too, jurisdictions will potentially be competing. The IMF is urging international discussion of taxation, because many tax measures naturally have cross-border implications.

However, the proposal in the EU for a small tax on all financial transactions has not won wider international support, especially not from the US. “If you increase the cost of transactions in one jurisdiction, markets will move to another – that’s how the Eurobond market arose in response to the US tax system. And the idea of an ­identical tax worldwide is wholly unrealistic. It has not happened even in the EU after many years of economic convergence,” says Paul Severs, a partner in banking and capital markets at law firm Berwin Leighton Paisner in London.

Mr Cottarelli says countries need to consider which forms of taxation are most suitable to increase. “It depends on the mobility of the tax base – corporate income taxes affect the mobility of production more than other forms. The taxation of immovable property by definition is different and could be considered as part of a package not only to raise revenues, but also to have a less distorting tax structure,” he says. In a similar vein, Adam Posen of the Bank of England’s monetary policy committee suggested in December 2009 a kind of “macroprudential” property tax rate that could be raised if the real estate market showed signs of overheating.

Moritz Kraemer, head of Europe, Middle East and Africa sovereign ratings at Standard & Poor’s, says that becoming a high-tax destination should not be ruled out if it helps restore the credibility of public finances. “Of course, it is easier if other countries are raising taxes at the same time. But the Scandinavian countries have relatively high tax rates, yet they have not been depopulated,” he says.

Privatisation potential

Divesting state sector assets is a quicker way of raising one-off revenues. Russell Julius, global head of equity capital markets at HSBC investment bank, has compiled a list of state stakes in EU companies that are already listed on stock exchanges – which makes these stakes technically easy to sell via secondary share offerings. The total value of state assets on the list is just under E324bn, with France alone accounting for more than one-third, and Germany and Italy each holding more than E30bn.

“There seems to be a lot of money around willing to buy these assets, many of which are utilities with reasonably transparent earnings, which are also reasonably leveraged to any recovery in GDP [gross domestic product],” says Mr Julius.

However, in the US and the UK, large-scale privatisation programmes in the 1980s have reduced the stock of appropriate state assets for sale. In the UK, only the two banks rescued by the state, Lloyds-HBOS and RBS, are on Mr Julius’ list. Mr Cottarelli warns that even selling all of the government stakes in the financial sector accumulated as part of the anti-crisis measures would only allow a one-off debt reduction of 4% to 5% of GDP on average.

Spending cuts

The expenditure side therefore looks set to carry a significant proportion of the correction process. Dramatic efforts by Canada and Scandinavia in the mid-1990s are cited as possible examples, but even these efforts took a decade to lower the public debt levels significantly. The Canadian government eliminated a budget deficit of 5.8% of GDP in just three years following the start of a spending review in 1994 and subsequently maintained a surplus until 2007.

Jocelyne Bourgon, the secretary to the Canadian cabinet at the time, was tasked with co-ordinating this monumental effort. One crucial part of the strategy, she says, was to avoid setting specific targets for each government department. Instead, the review process looped back on itself to continue looking for savings across each aspect of government activity.

“It is very difficult to set a good target; people will work to that target and you will never see what might have been possible in a different mindset. We said that the purpose of this exercise is to align the role of government in a manner that is sustainable to collective means,” says Ms Bourgon.

Mr Kraemer at Standard & Poor’s says eastern Europe can also help to point the way for the West. “France has had a target of replacing every two civil servants leaving with only one. One eastern European country has set that target at seven to one, so there is clearly more flexibility that governments are not yet making use of,” he says.

In addition, Canada had already reformed its pension system by 1994, which reduced the state’s future liabilities. By contrast, health care and pension entitlements are a growing part of the burden for several European countries as the average age of populations rises.

“Even before the crisis, when Ireland’s net debt was almost nil, it was set to grow to 100% of GDP by the middle of this century because of pension costs and demographics. Now, that 100% level is the starting point,” says Mr Kraemer.

Mr Adams says the US faces an equally daunting task. “It is easy to freeze discretionary spending, but this only accounts for 18% of the total budget. Entitlements constitute 60% of the budget, they are not part of the annual review process, they already account for about 7% to 9% of GDP and are growing faster than GDP, so that proportion is forecast to double by about 2030. That is cannibalising the rest of the budget,” he says.

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Jocelyne Bourgon, the secretary to the Canadian cabinet

These are, says Mr Adams, “deadly problems for politicians who live in a short-term world”, because the improvement in public finances plays out over many electoral cycles, but the unpopularity of benefit cuts is immediate. For this reason, so far, elusive bipartisanship will be vital to achieve results and convince markets that the reforms will be followed through.

While there is uncertainty about when the global economy will be strong enough to absorb heavy fiscal corrections, Mr Cottarelli says it is never too soon to begin setting out the strategy. To ensure that prudent budgeting is sustained through electoral cycles, the IMF is urging the creation of stronger institutional frameworks, including fiscal rules such as those recently written into the German constitution.

And Ms Bourgon says governments will need to reach out early, not just to the financial markets, but to the wider public. “This is not a traditional budgeting exercise, it is a societal exercise, so you must have more inclusiveness. It takes profound political commitment and courage,” she says.

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