Having burned its fingers by allowing a collapse of Lehman Brothers, the US Federal Reserve, and thereon other major Central banks were quick to pledge unlimited support so as to keep afloat beleaguered financial institutions. It was widely accepted then that it was the only way to prevent another great depression even if it mean leeching the taxpayer. A series of such helicopter drops thanks to exhaustive fiscal and monetary measures did extremely well in unclogging cash starved asset markets, mending tainted balance sheets and drastically reducing the systemic risk. Investors heaved a sigh of relief at this overtly generous gesture, pushing up the risk indices as they began to foresee no major event risk on the horizon. The lender of last resort had redefined its primary role by lending not just to depository institutions but also businesses groups, including auto majors and commercial real estate players. Concomitantly massive fiscal stimulus measures were announced aimed at pump priming the real economy which continued to face strong headwinds.
Having learned the lessons of excessive leveraging, financial institutions across the world embarked on a deleveraging drive, tightening their debt ratios while preferring to earn a low yet safe return on reserves rather than lend them to cash starved consumers. While such a hoarding behavior has done little to prop up real final sales across most major economies, the fallouts for the government have been even more worrisome. The concern of leverage has shifted from the financials to the government themselves as they continue to re-leverage themselves to seemingly unimaginable levels. Immense disparities between central bank credibility coupled with political and economic interlinkages amongst group nations means putting a lot at stake at the cost of another nation’s failure.
In this context, it was not surprising that members of the European Union, with the exception of Germany, pledged their support to a struggling Greece. Greece’s deficit has ballooned to around 12.7% of its GDP, way above the EU’s cap of 3%. With the nation facing more than 20 bn Euros in debt redemptions in April and May, it would likely struggle to fund its budget deficit sans support from other EU members. Amidst pressure from other EU members, Greece has pledged to reduce its budget deficit to 8.7 percent in 2010 by way of severe austerity measures, which would further cripple consumption demand in the struggling economy. Greece’s debt totaled 298.5 billion Euros ($407 billion) at the end of 2009. That’s more than five times what Russia owed when it defaulted in 1998 and Argentina when it missed payments in 2001. Amongst all nations, Japan has the largest debt, with official estimates of borrowings at 973 trillion yen (USD 10.7 trillion) by March 2011, more than the combined economic output of the U.K., France and Italy. Japan’s debt sustainability has been less of a concern so far since more than 90% of the country’s bonds are held domestically, thereby reducing the risk of capital flight. However, persistent decline in household savings rate coupled with a fall in JGB absorption capacity of the public institutions that hold about 40% of outstanding JGBs has raised concerns over the country’s debt sustainability going ahead.
From a nation’s taxpayer supporting domestic financial institutions to now supporting another sovereign is hardly an occasion to celebrate. Many may argue that no support would mean catastrophic implications for the Euro Zone and thereby for key global asset markets. However, while we take solace in the ‘it could have been worse’ notion, such measures do not leave the global consumer any better off either. The consumer in most developed nations still remains the missing link, capitulated by a fragile labor market, housing woes and tight lending standards. Underscoring this fact, the US Conference Board’s Consumer Confidence Index for February fell to its lowest level since July 2009. Meanwhile, bank lending in the fourth quarter of 2009 recorded a sharp 7.5% drop according to the Federal Depository Insurance Corporation (FDIC). Bank lending in 2009 fell at the fastest clip since 1942. Incessant small bank failures in the US are another major cause of worry, weighing further on consumer sentiment. 20 banks have already failed so far in 2010, bringing the total list of bank failures over the since January 2008 to 185.The FDIC’s list of ‘problem banks’ shot up during Q4-09 from 552 to 702, the highest number since 1993. FDIC expects total bank failures to cost USD 100 bn from 2008 to 2013.
The question of who will bailout the lender of last resort will continue to haunt market participants for some time to come. While most economies have already voiced their desire to deliver a credible pro growth fiscal adjustment program, such a process is expected to be extremely arduous, complex and long term. Last month, the US Federal Reserve Chairman, Bernanke acknowledged that the current US budget path was not sustainable although a downgrade of the country’s credit rating was unlikely. The US budget deficit (9.9% of GDP in 2009) is expected to stay high for many years to come as entitlement spending accelerates due to factors related to the aging of baby boomers (born between 1946 and 1964). A boost in interest payments due to massive accumulation of debt during the crisis years is another worrying factor over the longer term. Congressional Budget Office expects the overall deficit to begin rising again in 2015 in part because of a sharp rise in interest payments on the U.S. debt. In addition, there are massive budget issues in the largest US states. Amidst sluggish revenues and high spending demands, states are likely to face major difficulties in balancing their fiscal 2011 budgets. According to the Center on Budget and Policy Priorities, the combination of expected budget gaps next year and the current shortfalls leaves states facing a budget shortfall of USD 120 bn over this fiscal year and next.
With investors becoming more discerning than ever before, they are already demanding much higher premiums for the best of credits relative to levels prior to the Dubai and Greece crisis. CDS for sovereigns has seen a stark increase, led by Greece, which stands at a record 350 to 400 bps cost of protection. CDS spreads for Japan, UK and the US have also seen a notable increased off late but remain much below worrying levels. What is also alarming is that the appetite for Treasuries has declined by the largest amount in December with China and Japan reducing their allocation by USD 34.2 bn and USD 11.5 bn each to USD 755.4 bn and USD 768.8 bn respectively.
The ongoing global economic recovery has been a lot de-synchronized given varying economic and financial conditions across nations at the start of the recession. In the Non Japan Asia space, growth in most countries is expected to be robust and close to trend. Domestic demand is expected to be the key driver of growth in China, India and Indonesia while greater linkages with China would also prove beneficial for Korea and Taiwan.Restoration of global trade flows is also expected to be a potent source of support for global economic recovery. We have already begun to see the positive implications of a revival in trade with the emerging market economies largely benefitting from a strong bounce in exports. Commodity producers such as Australia and Canada have been relatively unharmed during the crisis period. However, for the major developed economies, namely the US, UK, Euro Zone and Japan, beyond the cyclical rebound seen so far, structural realities paint a dismal picture. The absolute levels of unemployment, consumption demand, housing market conditions and credit flow have a lot to improve before self sustainable growth can be assured. Whether measured by the output gap, the unemployment rate, or the manufacturing capacity utilization rate these economies are running well below their potential. In the US, although the labor market is showing incipient signs of recovery, a sustained improvement would depend a lot on broader economic growth, which is expected to be sluggish in 2010. The US economy has shed 8.7 million jobs since December 2007, the largest percentage points drop in payrolls since World War II. Output Gap, which measures the difference between the actual level of GDP and the level where GDP would be if the economy were operating at full employment, currently stands at a worrisome level of around negative 6%. Meanwhile, key issues facing Japan include a protracted deflation, an aging population and concerns over sustainability of government debt.
Against this backdrop, an orderly handoff from ephemeral sources of growth to sustainable sources of private final demand is imperative for a steady recovery across major developed economies. Thereby, the focus should be on achieving the two keys to a self sustaining recovery, namely, a pickup in household demand along with steady improvement in capex.
