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Sovereign Debt Crisis - A Roadmap for Investors
February 09, 2011

By Elga Bartsch, Daniele Antonucci, Arnaud Mares, Joachim Fels | London, Europe

By the end of March, European policy-makers will present broad-ranging reforms to contain the crisis.  In mapping out the different policy options discussed among European policy-makers, notably in the context of the reform of the European Financial Stability Facility (EFSF), we present an analytical framework to help assess the effectiveness of the measures that will eventually be announced.

 In This Issue
Sovereign Debt Crisis - A Roadmap for Investors
Fiscal Hope?
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 Joachim Fels
Joachim Fels is Morgan Stanley’s Chief Global Economist, based in London. He joined Morgan Stanley in 1996 to cover the German economy, became Co-Head of European Economics and the Firm’s first ECB watcher, and also built up the Currency Economics Team. Joachim then served as Morgan Stanley’s Chief Global Fixed Income Economist, Head of European Fixed Income Research, and more recently as Chief International Economist. Before joining Morgan Stanley, Joachim was an International Economist at Goldman Sachs from 1992-96 and a Research Associate at the Kiel Institute for the World Economy from 1987-92. He studied Economics at Kiel University, Saarbruecken University and the Bologna Center of the Johns Hopkins University’s School of Advanced International Studies (SAIS). The easiest way to follow Joachim’s thoughts on global macro issue is to subscribe to his weekly email Sunday Start.
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The key distinction in this framework is between measures that only provide additional liquidity and those that help to improve solvency directly.  The former can easily be implemented, because they do not involve any immediate costs.  The latter is more difficult to restore, because it involves foregoing income or consumption immediately: either the borrower through austerity measures, structural reforms or asset sales; or the creditor by writing off part of the debt, lowering the interest charged or extending the maturity. 

As long as emergency liquidity is available from the EFSF or other sources, countries will only default on their debt if they believe that it is in their best interest.  Restructuring is a particular concern for the euro area because its member states are considered between an emerging market government borrowing in foreign currency and a developed country with its own national currency.  Yet the cost of defaulting is considerably higher for a euro area country than it is for an emerging market government.  At the same time, the benefits of defaulting are also considerably smaller.

While even remote prospects of some form of default are rather disconcerting events for bond investors, markets systematically overprice such risks.  We cannot rule out an involuntary debt restructuring in the euro area in the coming years.  But we believe that the risks are more than adequately priced into government bond markets.

The restructuring hurdle in the euro area is higher than many investors appreciate, we think.  Calls for a default on the debt in the euro area periphery tend to be based on a partial analysis, which just focuses on debt sustainability, but does not look at the consequences of debt restructuring across the whole capital structure to grasp the costs and benefits that a rational government will take into account in its decisions.

The impact of a sovereign debt restructuring on the euro area financial sector remains uncertain.  However, it is vital for investors to consider the impact of such a debt restructuring, especially a compulsory one, on the different layers of the bank capital structure.  Together with initiatives towards bank resolution legislation and the ESM making private sector involvement compulsory in future debt restructuring, even senior unsecured bank debt has become less safe an asset.

Key Investment Implications

1. Peripheral government bonds have experienced a deterioration of some of their ‘institutional' and ‘behavioural' characteristics.  Investors looking for low risk, low return investments that usually characterize government bonds could continue to exclude peripherals from their portfolios, as they no longer exhibit such characteristics.  Such peripheral government-issued bonds will have to cheapen sufficiently to make them attractive within a broader asset-allocation context (e.g., versus credit such as IG & HY corporate bonds, equities, commodities, etc).

2. With country risk back as a main driver of investment decisions and portfolio performance, we think that euro area bond markets will continue to exhibit wide spreads, differently sloped yield curves and varying volatility.  And, to the extent that portfolio managers' mandates get changed to a greater extent towards AAA securities, this will further limit EMU peripherals' financing possibilities and potentially create difficulties in euro area financial markets.

3. Implementing an EMU-wide fiscal transfer mechanism that provides for bailouts of countries in trouble by the economically stronger euro area members would certainly help to solve the current sovereign crisis near term.  However, such a move to a ‘transfer union' creates the long-term risk of a political backlash in the countries shouldering the bill, which might ultimately even lead to EMU break-up.  Clearly, leaving the euro would involve serious political and economic costs for the seceding country (or group of countries).

4. The combination of even a remote prospect of EMU break-up and the severe sovereign debt crisis in the euro area have brought the country factor back with a vengeance when it comes to portfolio performance - both in equities and in fixed income.  In our view, country allocation decisions will remain very relevant going forwards over and above sector allocation, duration decisions and credit quality.  In addition, any future rally in the exchange rate will likely be capped by these uncertain but remote prospects of EMU break-up.

For full details, see Europe Economics: Sovereign Debt Crisis - A Roadmap for Investors, February 7, 2011.

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Fiscal Hope?
February 09, 2011

By Gray Newman, Arthur Carvalho | New York, Sao Paulo

In Brazil, as is the case in most emerging economies, all eyes are on the recent uptick in inflation and how policy-makers - particularly the central bank - will respond.  While Brazil has an inflation challenge - the consequence of robust demand and sluggish production (the Growth Mismatch), we suspect that the specter of inflation has been exaggerated a bit.  Moreover, while most of the focus remains on the policy response from the central bank, Brazil's policy mix for too long has placed too great of a burden on monetary policy even as fiscal and quasi-fiscal policies have remained accommodative.

Now comes word that Brazil may address its overreliance on monetary policy with a significant fiscal adjustment.  Indeed, the authorities could release as early as this week details of a fiscal adjustment that could involve a significant reining in of the fiscal accounts.  Even as we remain hopeful and would welcome a fiscal adjustment, we remain cautious.

Grounds for Caution

Our caution on both the magnitude and the scope of any fiscal adjustment in Brazil stems from three factors. 

First, Brazil has a long track record of overreliance on monetary policy, with insufficient fiscal efforts.  During the past decade, Brazil's fiscal burden has continued to grow no matter how measured - in local currency terms, in US dollar terms or, most worrisome, as a percentage of GDP.  Primary spending of the central government as a percentage of GDP has continued to climb during the past decade and reached nearly 20% of GDP by the end of last year, while the composition of spending remains heavily skewed toward pensioners and current expenditures.  Investment spending remains limited, reaching only 1.2% of GDP in 2010.  Indeed, the tax burden - the broadest measure of fiscal spending which incorporates both federal and subnational spending - has continued to grow as a percentage of GDP reaching 33.4% in 2009.  In years of strong growth as well as in years of weak growth, election years and non-election years, government spending has continued to grow.  The authorities may now reverse that trend, but it is worth noting that the track record during the past decade has been one of ever increasing public spending.

Second, not only has Brazil's track record shown the ever-increasing weight of state spending, but in recent years the authorities have increasingly turned to special accounting conventions that have served to overstate final fiscal balances.  In 2010 alone we estimate that Brazil's primary surplus would have been much smaller - closer to 1.8% of GDP, rather than the reported 2.8% of GDP - relying on non-recurring revenues. The authorities have been able to provide funding to the national development bank, BNDES, off-balance sheet and without having an impact on the net debt of the public sector (new borrowing by the federal government to fund BNDES is offset by an asset, BNDES's promise to pay), but BNDES has in turn helped ease the expenses related to capitalizing the state oil company, effectively freeing up public spending for the federal government.

Indeed, although Brazil's overall fiscal balance appeared to have improved in 2010 - the officially reported budget deficit was only 2.6% for the year, we argue that the underlying or cyclically adjusted deficit has worsened in the past two years.  If we take the average growth rate for GDP and Brazil's terms of trade during the five-year period of 2000-04 as a proxy for a ‘structural' revenue stream, we find that the ‘structural' or cyclically adjusted balance deteriorated sharply in 2010. 

Third, Brazil's fiscal accounts have very limited flexibility making any significant fiscal adjustment extremely difficult.  In the 2011 budget, nearly three-quarters of the R$773 billion budget is non-discretionary.  And most of the remaining R$220 billion in ‘discretionary' spending includes almost the entire healthcare budget, half of the education budget, the PAC investment program and the highly visible Minha Casa Minha Vida housing program.  All of these items are quite politically sensitive, making it difficult for the government to successfully implement meaningful cuts. 

There has been a discussion that the spending adjustment could be as large as R$50-60 billion.  We find it difficult to imagine that a fiscal adjustment could be implemented of that magnitude: that is nearly one-quarter of the entire discretionary budget.  And it is worth noting that even if just over R$50 billion of cuts could be made (the amount needed to reach the 3.1% primary surplus without special accounting treatment), total spending would still rise in real, inflation-adjusted terms.  The alternatives to a spending cut of this magnitude would be either some offsetting measures designed to boost revenues (a worrisome development given Brazil's already high tax take) or a structural change that opens up some of the 'non-discretionary' parts of the budget.  Indeed, we would argue that a successful fiscal adjustment should contain three elements.

Grounds for Optimism

What will we be looking for to judge the success of any fiscal efforts? We would highlight three elements that would give us reason for optimism.

First, given the current dilemma that Brazil finds itself in - robust demand accompanying stagnant production (the Growth Mismatch), the authorities should aim for no additional fiscal stimulus.  Indeed, given the pace at which demand is outstripping supply, Brazil's fiscal efforts should be geared to reining in demand pressures by running an overall public sector surplus.  Of course, such a radical departure from the 2011 budget that has already been approved by congress is unlikely to be announced during February even though Brazil's executive branch does have the flexibility to set lower spending ceilings through ministerial decrees.  But we would welcome any first signs of policy movement that targets Brazil's overall fiscal balance (currently a deficit) rather than the primary balance. 

Second, any fiscal effort should pave the way for a reform of Brazil's growing non-discretionary spending formulas.  The limited maneuvering room provided with discretionary spending should prompt the authorities to revisit social security reform.  At the present, pension benefits rise not only with inflation (keeping pension benefits from being eroded by inflation is a laudable goal), but also with the increase in the minimum wage (which has consistently run above inflation).  And private-sector employees still have no minimum age provisions as long as the provisions regarding the length of contributions are met.  The result: Brazil's total pension costs as a percentage of GDP rival those of many northern European countries even though Brazil's demographics reflect a much younger population.

Third, Brazil should move towards adopting a fiscal rule that provides for an overall structural fiscal balance or surplus.  Given the important revenues expected to be associated with Brazil's new oil and gas fields, it can be argued that future generations would be best served with a fiscal policy that aims for a structural surplus or at the very least a cyclically adjusted fiscal balance with excesses funding new investment projects. 

Of course none of these measures - a shift in focus from targeting a primary balance to an overall budget balance, a series of reforms in the pension sector, a structural or cyclically adjusted balance - are likely to be fully implemented in 2011.  But progress on each of these three fronts would help Brazil wean itself off of its overreliance on monetary policy and pave the way for lower real interest rates.

It is important not to confuse the longer-term structure challenges for Brazil  -included the need to reduce real interest rates - with the near-term challenge that Brazil is facing with a business cycle where demand is outstripping supply.  At times we are concerned that the new administration may be overly optimistic regarding what can be accomplished on the fiscal front in the near term and what the implications would be for interest rates in 2011.  While a comprehensive fiscal reform can lay the groundwork for a reduction in interest rates, we expect 2011 to be a year of rising, not falling interest rates.  (The precise mix between interest rate and non-interest rate measures by the central bank is still not known, although we remain in the camp that the authorities will rely more heavily on non-interest rate measures than most market participants expect.  After all, after arguing for the past eight months that the Growth Mismatch - the growing divergence between robust demand and weak supply - was in large part the consequence of the multi-decade strong currency, December's surprisingly weak industrial production report has finally attracted attention to our concern and that of the authorities).

Bottom Line

The advent of a new administration provides a promising opportunity to rethink the imbalance between Brazil's fiscal and monetary policies.  We welcome and encourage the renewed interest on the part of the new economics team to revisit Brazil's fiscal accounts and agree with the assessment that a fiscal adjustment is a precursor to lower interest rates.

But we would argue that the fiscal adjustment needs to be structural in nature.  The current earmarks and weight of non-discretionary spending virtually rule out the possibility that Brazil can implement a large enough fiscal effort in 2011 that would allow fiscal policy to act counter-cyclically.  While fiscal measures can reduce - but not eliminate - the fiscal impulse in 2011, a set of structural fiscal reforms can put Brazil on a healthier path, allowing it to simultaneously reduce the burden on the central bank and on interest rate policy while freeing up much-needed public resources to fund the important infrastructure needs of Brazil.

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