Friday, 8 April 2011

The Puke Point

What, my wife asked, knowing that sometimes I need an outlet to talk debt, is going on in Portugal? What is this mess they’ve got into?

Earlier that day Portugal’s caretaker Prime Minister had given into the inevitable and started talks with the European Union on a bail-out financing. Reports suggest the country needs financial support of 70 – 90 billion euros.

It’s a tough situation for a country that’s seen several years of hard times. There’s been years of deficits, recession, a failed austerity budget and then, pushing it over the edge, the parliament refused to pass a second austerity budget, triggering Prime Minister Socrates to stand down and call new elections, due 5 June.

The Prime Minister continued to resist help, but the final straw was the threat by Portugal’s biggest banks to stop buying government bonds. They had reached the puke point, where bond buyers lose their appetite to buy debt. On Monday, Portugal held its (semi-regular) auction to sell government bonds and had to pay 5.1% on six-month debt and 5.9% on 12-month debt – far higher than the country can afford over the long-term, and would have to rise further if the Portuguese banks made good on their threat.

And governments cannot choose to ignore the debt markets. Auctions of debt are routine for all large economies, and the results are made public. And in between these auctions there are a variety of ways (primarily secondary trading and CDS) that indicate market appetite pretty much in real time.

For Greece, bond auctions in the first months of 2010 indicated that lenders had grown queasy of buying Greek government debt; the puke point was not far away. By March, Greece had agreed a rescue package from the international authorities.

Last September, the Irish government decided to cancel all planned bond auctions, seeking to shy away from bondholders’ unpleasant message. However, CDS levels rose through October and ended up indicating Ireland would have to pay in excess of 7% to borrow. By November, Ireland had begun bailout talks.

There are differences between Ireland, Portugal and Greece. In Ireland, the government made a rash decision in 2008 to offer a blanket guarantee to the country’s banks. (In hindsight, this was one of the most expensive decisions ever taken by a small country.) By contrast, banks in Greece and Portugal are not in need of a bailout, and in many circumstances are held back by the weakness of the sovereign state’s credit rating.

In Greece and Portugal, but not in Ireland, the banks have traditionally bought a high proportion of the government’s debt. By doing so, governments were given an easy source of funding, but these banks tended to be owned by the state and acting in the interests of the state, so have been stuffed with low-priced – uneconomic – bonds. They had no puke point; the taxpayer would ultimately pay for their largesse through regular banking collapses and financial crises.

Since joining the euro, these countries have been able to reduce their dependence on their domestic banks, finding instead foreign bond investors more than willing to lend. These investors believed that Europe’s periphery offered a ‘convergence play’ – ie that the poorer countries of Europe were on a journey that would see them end up with similar credit profiles to that of the richest, but in the meantime they would pay higher interest rates than countries such as Germany and the UK. Investors’ largesse combined with poor governance, and Greece saw its sovereign debt balloon to more than 290 billion euros, most of it held by foreigners.

So that’s Portugal, Greece and Ireland dealt with, is there anything here that’s relevant to the UK? Only today The Guardian splashed its front page with attacks on Chancellor George Osborne ("desperate ... scaremongering" according to Shadow Chancellor Ed Balls). Critics of austerity at the leftist blog Liberal Conspiracy took Osborne to task. Here is one of the better-informed critics today:

“Tough austerity is a self-defeating strategy.

Several commentators have been quick to point out that Portugal, Ireland and Greece had ‘no choice’ but to adopt these policies. Now whilst there is always a choice, I fully accept that in each of those cases membership of the Euro, the maturity profile of outstanding debt that needed to be refinanced and loss of confidence from the bond markets forced the government’s hand.

But this doesn’t change the fact that austerity isn’t work and is unlikely to work.”

According to this commentator, who at least seems to know the difference between debt and deficits,

“The key difference between Britain and the Euro-Periphery is that Britain certainly does have a clear choice – we have the longest debt maturity in the developed world, the markets are prepared to lend to us at near record lows (and have been for over two years – not just since the emergency budget), our debt/GDP ratio is comparatively low. Whatever the scare-mongers say, Britain was nowhere near the brink of bankruptcy.”

This is a  curious and elusive use of phrasing, concepts and numbers. It is true that Britain was not near bankruptcy, as David Cameron once (in 2009) unwisely claimed. It was untrue then and it’s untrue now. And, yes, the UK has stretched its debt maturity (as have other developed world countries) for the last couple of years, taking advantage of continued investor appetite for UK debt.

So, nothing to worry about then?

Well, not really. What’s noticeable about Mr. Weldon’s peon to the UK’s creditworthiness is that he doesn’t mention the main group of people concerned about the UK’s debt: the credit rating agencies. And these have issued frequent warnings about the UK’s debt position. As noted below, one of these, Moody’s, said last month that the UK’s Aaa rating remained at risk, and explicitly praised Osborne’s plans to cut the deficit.

Until now, the UK has seen its debt climb at a dizzying pace but has maintained investor confidence. The puke point appears some way away. However, and as the Moody’s report makes clear, this confidence is substantially connected to the government’s determination to reduce the deficit. Investors have seen the UK as a safe haven, but there is no law that says this will always remain the case.

If there is one thing we should have learnt from the financial crisis is that high debt levels mean investor confidence can be lost almost overnight. The puke point is never far away. The complacency of the anti-austerity critics, and this includes the Labour opposition, seems breathtaking in this regard. The difference between Portugal and the UK is that investors in Portugal reached their puke point; given the UK’s high level of debt there is no reason to suggest the same could not happen to the UK.

Addendum: the only way that the UK could be sure of continuing to borrow without a care for investor confidence would be turn the clock back and stuff state-linked banks (such as RBS) with government debt. Though such cronyism has long since been banned by Europe, it is one logical extension of the arguments made by the anti-austerity brigade.

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