Friday, November 28, 2008

Sovereign Default - A Study

From the FT, a quick summary of the status of the UK financial position and why its CDS spreads keep expanding by the day:

The horrific numbers for fiscal deficits contained in the PBR might give pause. The government’s net borrowing is now forecast at 8 per cent of gross domestic product in fiscal year 2009-10, 6.8 per cent in 2010-11, 5.3 per cent in 2011-12, 4.1 per cent in 2012-13 and 2.9 per cent in 2013-14. Public sector net debt, supposed to remain below 40 per cent of GDP, is forecast to reach 57 per cent four years hence. If one paid attention to the requirements of the Maastricht treaty, which laid the way for the eurozone, the debt ratio would reach 68.6 per cent of GDP in 2012-13, while the deficit, supposed to be below 3 per cent, is forecast to hit 8.1 per cent next year and would be 3.3 per cent in 2013-14.

So how did the public sector’s net borrowing jump from 2.6 per cent last financial year to 8 per cent next year? Why has the forecast deficit for next year jumped by £80bn (5.4 per cent of GDP) since the Budget delivered just last March? And why, not least, should one believe the Treasury now?

Part of the explanation is the decision to apply a temporary fiscal boost of £16.5bn (1.1 per cent of GDP) next year. But this counts for only a fifth of the slippage. The rest is due to “revisions and forecasting changes”. Virtually all of this – 5 percentage points – is, argues the Treasury, due to deterioration in the “cyclically adjusted”, or structural, borrowing requirement, now forecast to reach 7.2 per cent of GDP next financial year. In short, the Treasury is telling the world that the view of the structural fiscal position of the UK it held last March was nonsense.

What changed so drastically? As a share of (a smaller) GDP, current receipts are now forecast to be 3 percentage points lower in 2009-10, current spending 1.9 percentage points higher and investment 0.6 percentage points higher than was forecast in the Budget. These changes are overwhelmingly due to revisions in the fiscal capacity and level of GDP: a permanent reduction in taxes on financial sector profits and housing transactions; and, more strikingly, a lasting loss of GDP. In 2010, the economy is now expected to be some 5.5 per cent smaller than forecast in the Budget. Worse, this loss is not going to be made up in the near future. In 2015, GDP might be 4.5 per cent smaller than hoped last March.

What implications do these drastic revisions have?

First, the Treasury’s view that the last cycle ended in 2006 seems quite ridiculous. The correct view is that the UK has been caught in an unsustainable supercycle, with a once-in-a-lifetime bubble in global finance and domestic housing. It is only now in the downswing. The cyclically adjusted fiscal deficit, properly measured, was far larger than believed for at least a decade. So fiscal policy should have been much tighter. If it had been, the UK would be in far better shape today.

Second, the UK cannot afford the spending it once hoped for. The government recognises this: current spending is forecast to grow at only 1.2 per cent in real terms from 2011-12 and net investment to fall by 0.9 per cent of GDP. As a result, spending is forecast to fall from 44.2 per cent of GDP next year to 41.5 per cent in 2013-14. Even so, tax shares must also rise: the PBR forecasts a rise of 2.4 percentage points between 2009-10 and 2013-14. Misery lies ahead for years.

Third, even so, the Treasury surely remains too optimistic: despite the scale of the shock to the world economy and the financial system, it assumes an annual peak to trough decline in GDP of a mere 1 per cent; an economic recovery in the second half of next year; and then a return to trend growth at 2¾ per cent a year, despite the need to shift output into capital-intensive, export-oriented manufactures. This is not plausible.

Finally, assume, instead, that GDP shrinks by 2 per cent in 2010 and 2011, before expanding by 1.75 per cent in 2012. It would then be 11 per cent lower in 2012 than forecast in the Budget. The fiscal accounts would be drowning in red ink.

Everything depends on avoiding a deep and prolonged recession. In that event, markets might even reject the explosive increase in government debt. Letting bank lending stay frozen is not an option. The government surely knows that. Do the bankers?

I don't think they are intentionally letting bank lending stay frozen. The only thing they could do now is to take over the bank in full nationalization. Oh, Right.

. Now.


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