Month: November 2010

Buiter’s Bombshell

At the risk of adding to the gloom, here is Willem Buiter’s widely discussed “Sovereign Debt Crisis Update.”

A sample:

Despite the recent drama, we believe we have only seen the opening act, with the rest of the plot still evolving. Although we have not had a sovereign default in the AEs since the West German sovereign default in 1948, the risk of sovereign default is manifest today in Western Europe, especially in the EA periphery. We expect these concerns to extend soon beyond the EA to encompass Japan and the US.

Accessing external sources of funds will not mark the end of Ireland’s troubles. The reason is that, in our view, the consolidated Irish sovereign and Irish domestic financial system is de facto insolvent. The Irish sovereign cannot from its own resources ‘bail out’ the banks and make its own creditors whole. In addition, a fully-fledged bailout (permanent fiscal transfer) from EA partners or the ECB is most unlikely. Therefore, either the unsecured non-guaranteed creditors of the banks, and/or the creditors of the sovereign may eventually have to accept a restructuring with an NPV haircut, even if it is not a condition for accessing the EFSF or the EFSM at present.

 

Rollover Risk and the Crisis Resolution Mechanism

Gauged by yesterday’s market reaction, the EU-IMF support package did little to dampen longer-term default worries on Irish debt.   The yield on the 10-year bond rose on Monday after an initial rally, even as the yield on 2-year bonds fell.   Potential buyers continue to have a number of doubts about Ireland’s creditworthiness:  doubts about the political capacity to produce the necessary primary budget surplus; doubts about whether sufficient nominal growth can be generated to stabilise the debt to GDP ratio even with an impressive turnaround in the primary balance; and doubts about how the direct cost of the banking bailout will impact the starting level of debt. 

There has been a lot of discussion of an additional source of doubt that is largely outside of our control: the rules of the new EU resolution regime that will be in place for government debt.   It is not immediately obvious why the arrangements that will be in place from 2013 should have such a bearing on the cost of borrowing today.   However, the new regime will affect the cost and ease of rolling over debts, and so forward-looking investors must look beyond the resolution arrangements that apply to bonds purchased now.    It seems likely that today’s potential investors worry that it will be more difficult for countries such as Ireland to roll-over debts under the new rules. 

The proposed rules reflect a watering down of the tougher arrangements advocated by Germany.   Under the new proposals, a country has to be deemed to have an unsustainable debt to trigger collection action clauses to restructure existing debt as part of any bailout.   Even so, there is an expectation that it will be more costly to raise funds in the future.   

What are the implications for the policy effort to restore Ireland’s creditworthiness?   The nature of the new regime suggests that a country lacking in “fiscal space” could pay a large risk premium in the future.   This could explain why even the expectation of successfully stabilising the debt to GDP ratio at a high level still leaves a country vulnerable to perceived roll–over risk.   Unfortunately, there is no easy solution, but it does suggest the importance of adopting a national fiscal regime aimed at ensuring fiscal space (e.g., putting in place such measures as an independent fiscal council and appropriate fiscal rules).  

I don’t think the report on fiscal governance by the Joint Oireachtas Committee on Finance and the Public Service – and in particular Philip Lane’s excellent background paper for the Committee – received sufficient attention (the report and background paper are available here).   Moving to put the necessary institutions in place may not just be essential to improve fiscal policy in the future, but also an essential part of restoring creditworthiness today in a context where perceptions of future fiscal space are so critical.   

Cancun, climate, and weather

Fokke & Sukke are proud weathermen The outcome of the climate negotiations … can now be predicted months in advance.

The 16th Conference of the Parties to the United Nations Framework Convention on Climate Change and the 6th Meeting of the Parties to its Kyoto Protocol has started today in Cancun. It will last for two weeks. Unlike last year’s conference/meeting in Copenhagen, expectations are low this time. Again, results will be minimal.

The economic crises, the results of the mid-term elections in the USA, climategate, and the deception of Copenhagen are often listed as reasons why Cancun is unlikely to lead to a breakthrough. I would add that the international climate negotiations repeat the same moves over and over again. If something did not work the last 10 times, why would you try it again? I’ve argued elsewhere that the international framework for climate policy is complete, and that we should now focus on reducing national emissions at minimum cost.

There is another similarity between Copenhagen and Cancun. It’s winter. There are slow oscillations in the climate. Experts reckon that cold winters may be with us for another decade or so. After that, trend and cycle will conspire to rapid warming.