Wednesday, 9 December 2009

Austerity and the financial markets

Michael Burke: Financial markets have a great many faults. But they can frequently provide a signal of their participants’ collective thinking with much greater clarity than their cheerleaders and their ideologues. This is especially the case currently, with regard to the risks of increased government spending. Most governments are currently engaged in a policy of reflation. Yet there are already parties seeking office, in Britain and elsewhere, who favour a policy of fiscal contraction.

In Ireland, the Party of Austerity is already in power. We are frequently told that bond market investors are demanding Ireland’s unique austerity experiment, and that otherwise they will refuse to purchase the government debt. Finance Minister Lenihan has said that that taking “decisive action” on the budget deficit was a priority for the Government and it would “signal to international investors that the Irish Government possesses the ability to take the necessary action”.

Let us ignore here the impositions of Maastricht of 3% borrowing and 60% debt in relation to GDP. Everyone else has in Europe has as they go about attempting to reflate their economies. Instead, for bond investors, it is easy to put a number to the fear and greed that drives financial markets. The latter, greed, is what they demand in the form of the yield on government debt at auction. The former, fear, concerns the risk to the principal sum in the form of default. And the two are related.

Yields on benchmark Irish government debt were 4.85% as of close of business on Friday December 4 (all yields from Financial Times, December 7, page 29). That’s considerably below the peak of 6.02% in January of this year. That must surely mean that the bond market is reassured by the austerity measures to date? Well, no. The first ‘decisive’ austerity measures from the FF/Green government were in October 2008, and yet yields soared in January of this year.

It can be useful, in judging the financial market impact of policy, to look at yield spreads. The riskier the asset, the higher the spread, and movement in the spread signals a change in the perception of that risk (the fear/greed factors again). The yield spread of Irish 10year debt over the European benchmark German debt is a very sizeable 1.62% (or 162 basis points, or bps in the jargon). That represents a very large, additional cost to the Irish taxpayer and compares to the next highest yield spread of Italy of 0.79%. Only Greece has a higher spread in Europe, of 1.71%.

But a key fact is that this yield spread has been widening against Irish taxpayers. Over the past 12 months German yields have risen by 0.19%, while Irish yields have risen by 0.62%.

Now, against a possible charge of unfairness, it should be admitted right away that, if financial markets are in a panic, the riskier asset will be harder hit than the safer one. In this case the riskier asset would be Irish debt and the safer one German debt. But we have already seen that the big sell-off occurred in January, and in fact most yields have been declining since.

It is possible to develop this point further, by using a more direct parallel with Ireland’s debt. A comparison with Belgium is a very useful one because:

a. Belgium is a middling Euro Area economy, with its yield spread close to the average of the Euro Area, below Italy, Spain, Portugal, and others, and above that of France, The Netherlands, Austria

b. Belgium has a much higher government debt than Ireland but a much lower current budget deficit, and, crucially,

c. For virtually the whole of 2008, the yield spread between Belgium and Ireland was, for the reasons in (b.) almost identical, usually within or 1 or 2 bps of each other.

However, that is no longer the case. Belgium’s yield spread over Germany is now 0.33%, or approximately one-fifth of Ireland’s. The Irish government’s Pre-Budget Outlook estimates an increase in net debt this year of €26bn. With Belgian, rather than Irish yields at that maturity, Irish taxpayers would save approximately €340mn next year, and every year for the lifetime of the debt.

But there is a striking feature of the divergence in Belgian and Irish benchmark yields. The thrust of fiscal policy for the two economies has been diametrically opposed; Belgium in common with the overwhelming majority of leading economies in the Euro Area and elsewhere has been attempting to reflate its economy with a combination of increases in government spending and temporary tax cuts, amounting to 3.6% of GDP. The judgement here is that the former are likely to be more productive. But Ireland has engaged in a unique contractionary experiment, amounting to 6.4% of GDP once the December 2009 Budget is included, in order, we are told, to reassure bond markets. Yet the verdict seems clear. Irish yields have risen compared to Belgian yields. As far as the bond markets are concerned, Ireland has become a relatively riskier bet because of its austerity policy, not despite it.

In case there should be any doubt, a closer examination of the Belgian/Irish yield spread confirms this analysis. As mentioned previously, for nearly the whole of 2008 the yields were almost identical. However, they began to part company in October 2008, precisely the time of the first Irish austerity budget, which was brought forward to “reassure financial markets“. From a yield spread of zero at the beginning of October 2008, it began to move against Irish taxpayers, to 0.25% at the end of that month, to 0.75% by the middle of December, to 1.30% currently.

Now, if you ask most bond investors and certainly most government bond analysts (as they are, daily, in all the media outlets) they will say the Irish government is doing the right thing, biting the bullet, upfront pain, and so on. All this proves is you don’t need to be well-versed in accurate economic theory to buy a bond, nor to be employed at a stockbrokers which sells them. But it helps if you can see what’s actually happening. There are honourable exceptions. According to Michael O’Sullivan, head of asset allocation at Credit Suisse Private Banking, “Arguably the Irish bond market is being saved at the expense of Irish society”.In reality, both are facing potential disaster as a consequence of the same disastrous policies.

Belgian reflation has led to falling forecasts for the deficit (because of stronger growth), while Irish fiscal contraction has led rising deficit forecasts (because of weaker growth). According to the European Commission, the difference between Ireland’s and Belgian’s budget deficits in 2008, when yields were the same, was 6% of GDP (Ireland 7.2%, Belgium 1.2%) and is now expected to be 9% in 2010, with Ireland’s rising and Belgium’s falling. At the same time Irish yields have been rising compared to Belgium’s.

The market verdict is clear. Reflation is the route back to government solvency; fiscal contraction increases costs and can lead to disaster.


Pavement Trauma said...

Are you seriously suggesting that borrowing more would improve the interest spread on our borrowings?

The key difference between us and Belgium is that their current deficit is under 6%, due to cyclical reasons and mostly domestically funded while our (official one, not including NAMA) is over 12%, substantially structural and mostly funded from foreign sources. *That* is why they have a lower interest spread.

Michael Burke said...

@ Pavement Trauma

Yes. As long as it was borrowed to reflate the economy. All the Reflationists in Europe have seen their yields fall versus Ireland's unique contractionary experiment.

Belgium didn't start with a lower spread; in 2008 the yields were the same. Belgium's debt was also under 6% of GDP then. So that can't possibly be the cause of the subsequent divergence in yields. And estimates of their structural deficit haven't changed either.

What has changed in that time is that Belgium borrowed to reflate. Ireland cut, and then (predictably) found tax receipts plummeting, so the deficit went up, while Belgium's deficit has stabilised and is expected to fall.

The alternative, apparently seriously conducted by sober men and women, is to increase Ireland's borrowing to pay for the self-inflicted wounds caused by austerity.

According to the OECD Ireland's fiscal contractions will amount to 6.4% of GDP after today. That's getting on for half the entire expected fall in GDP from the recesion. Even doing nothing would have been much better.

PPP Lusofonia said...

See the ECB's Harmonised Competitiveness Indicators, which point to considerable intra-Euro area divergence.
Countries with productivity gaps and external balances are more vulnerable, and the market is being more descriminating.
SEE PPP Lusofonia,