l Global Research l Special Report | 20:45 GMT 22 July 2011

Developed-country debt crisis Four ways out

High debt ratios can be reduced in four ways: austerity, growth, inflation and/or default The euro-area crisis is not over, with more defaults possible and even EUR exits US debt-ceiling theatrics are risky, but we are confident that the US will adjust

Summary
High developed-country debt burdens can only be reduced via some combination of four approaches: austerity (preferably spending cuts rather than tax increases), economic growth, inflation (via devaluation), or default. We analyse which routes are most likely to be taken by the major problem countries (Table 1 below). The 21 July euro-area summit eased terms for Greece, but not enough to restore debt sustainability. The summits endorsement of a formal Greek default, at Germanys insistence, will keep investors nervous. A major concern is that there is barely enough money on the table to fully cover Spain, let alone Italy, if market contagion resurfaces. Germany is very unlikely to accept a full fiscal union, but the current muddling through approach may not be enough unless Spain and Italy can quickly reduce deficits and boost economic growth. A disorderly combination of defaults and euro (EUR) exits would be a major new shock to the world economy, although the results might not be as serious as in 2008-09. Asian countries are relatively well insulated. There are increasing hopes that US debt-ceiling theatrics might yield a significant fiscal agreement, though US politics are unpredictable. We are confident that, over time, the US will reverse the upward trend in its debt ratios, primarily through a combination of austerity (particularly spending cuts) and economic growth. We have similar confidence about the UK, where progress is already being made. Japans route to fiscal sustainability is hard to discern. It has a large budget deficit and anaemic growth and deflation, yet we view default as highly unlikely. We expect that a combination of austerity and inflation (via devaluation) will be the answer. Table 1: Likely importance of each route to debt reduction Countries will probably use more than one
Austerity Cut spending, raise taxes Medium High High Medium Medium High High Medium Growth Requires reform and investment Low High Low Low Low Medium High High Inflation Requires devaluation Very possible Possible Possible Likely Very possible Possible Limited Limited Default Easier if losses borne by foreigners Certain Very possible Possible Very unlikely Very possible Possible Very unlikely Very unlikely
John Calverley, +1 905 534 0763
John.Calverley@sc.com

Greece Ireland Italy Japan Portugal Spain UK US

Source: Standard Chartered Research

Important disclosures can be found in the Disclosures Appendix All rights reserved. Standard Chartered Bank 2011 research.standardchartered.com

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Debt concerns rising

Contagion threat spreads to Italy
Contagion to Italy has taken the euro-area crisis to a new level In a report published in early May, we said, A full-blown crisis would arise if Italy has difficulties with rolling debt or if popular pressure radically changes the German governments approach (Special Report, 5 May 2010, Q&A on the euro-area crisis). At the time, we envisioned these risks as a potential threat down the road. Instead, they emerged just weeks later. Germanys insistence on private-sector participation in helping to meet Greeces funding requirements (though perfectly justifiable from a tax-payer point of view) opened a Pandoras box. Perhaps Greece would have opened it anyway before long, by just saying no to further adjustment and beginning to ask for restructuring. But now that the box is open, it will be very difficult to close. When the rating agencies stated that unless any restructuring was entirely voluntary it would be treated as a selective default (SD), it looked at first as though Germany would back down. But the German authorities seemed to conclude that if even a small contribution from the private sector would receive a selective default (SD) rating they might as well tackle the problem robustly. The 21 July summit formally endorsed debt reduction for Greece, which will involve investor losses of about 21% via debt rollovers or swaps. The rating agencies are likely to assign a SD rating, at least for a time, and investors will worry about default spreading to other countries. Markets have long believed that Greek debt would need restructuring at some point, but the onset of austerity fatigue in Greece and bail-out fatigue in Germany has come earlier than expected. With Germany forcing a restructuring on Greek creditors, there are fears that other countries might follow. How much tolerance of austerity fatigue do other populations have, if growth stays negative or sluggish? With competiveness weak, this is a real risk. Restoring competitiveness via deflation makes debt burdens worse, while achieving it via structural reforms will continue to meet political resistance. Ireland, Portugal and Spain are the prime suspects in line behind Greece, but Italys slow pace of adjustment, even though it has less adjusting to do, has raised market fears.

Table 1: Euro-area debt crisis scorecard

Country Nominal GDP Rating (2010, (Weakest EUR bn) rating) Public debt to GDP (2011E,%) Budget deficit (2011F, % GDP) Primary deficit (2011F, % GDP) Gov. debt held abroad (2010, %) Household debt to GDP (2009,%) GDP growth (2011F, %) Current account (2011F, % of GDP) Banks Tier 1 ratio (H1-10,%) House prices (since Q1-07, %)

Germany France Italy Spain Netherlands Belgium Greece Ireland Portugal Euro area

2 498 1 948 1 548 1 051 586 352 232 157 171 9 172

AAA AAA A+ AA AAA AA+ CCC Ba1 Ba2

75.9 86.8 120.2 69.7 66.6 100.5 150.2 107.0 88.8 86.5

-2.7 -6.3 -4.3 -6.4 -3.9 -4.6 -7.4 -10.3 -4.9 -4.6

-0.3 -3.5 0.2 -4.6 -2.2 -0.5 -0.9 -7.5 -1.6 n.a.

52.8 64.4 47.0 49.6 66.4 68.3 61.5 59.4 56.7 n.a.

63.9 69.5 56.5 90.2 130.4 54.5 62.1 124.9 107.5 66.0

2.5 1.8 1.1 0.7 1.7 1.8 -3.0 0.9 -1.0 2.0

4.6 -3.4 -2.7 -3.8 6.8 2.0 -8.0 1.5 -8.0 0.0

10.7 10.3 8.6 9.1 11.4 14.1 10.2 10.3 8.2 n.a.

0 5 3 -23 -2 13 -6 -38 7 n.a.

Sources: Bloomberg, EU Commission, ECB, CEBS, BIS, IMF, Standard Chartered Research
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We still think Spains fiscal position is better than Italys and the market is coming around to our way of thinking

In another report, published last year, we argued that the long-term fiscal sustainability of Spain is better than Italys (On the Ground, 19 May 2010, Europe Spain, Italy default risks are low). Although Spain has a larger deficit and more problems in the private sector, with the collapse of the construction market, it also begins with a far lower debt ratio (70% at end-2011 versus 120% in Italy) and seems more capable of regenerating economic growth. The markets were not seeing it the same way then, with Spains spreads and CDS significantly higher than Italys. As recently as mid-June, Spain was paying 4.8% on 5Y government bonds, while Italy was paying only 4.0%, versus Germanys 2.2%. However, in the last week, Italian and Spanish yields converged above 5%, though yields have since fallen back to 4.75% and 4.95% respectively. They are still below the 6-7% level which would be unsustainable over the long term, but not comfortably so.

EFSF may be too small now to fully cover Spain; certainly not Italy
With more money agreed for Greece, and possibly more needed for Portugal and Ireland the European Financial Stability Fund (EFSF) now has enough funds to provide liquidity to Spain for only a year or so if market borrowing costs become too high. The additional flexibility for the EFSF agreed at the summit means that the available money could be used for financial support without a formal programme and also for debt purchases, a welcome change. But the EFSF urgently needs more funds. To have enough to cover all of Spain and Italys borrowing requirements until 2014 (new borrowing plus rollovers) would require the EFSF to double or even triple in size. However, since neither Italy nor Spain could contribute if contagion returns to Italy, the burden on France and Germany would be correspondingly higher.

Muddling through may not be enough

Germany may eventually have to choose between fiscal union or accepting defaults, or even exits from the EUR If markets lose confidence in Italy as well, Germany would have to choose between accepting the burden of fiscal union or facing the turmoil of defaults and possible EUR exits. We still feel that dropping the EUR itself is extremely unlikely it is in Germanys interest to stay in a single currency environment that includes France and other relatively closely integrated countries. But moving forward to fiscal union is almost as unlikely, despite the hopes of European integration enthusiasts. The political institutions are not yet in place to make this a safe option for Germany, let alone a desirable one. Germany would face higher borrowing costs and its credit rating could be at risk.

Chart 1: 5Y government yields surge Greece leads the way

25 20 15 10 5 0 Jan-00 Dec-09 Mar-10 May-10 Aug-10 Oct-10 Jan-11 Mar-11 Jun-11 Sources: Bloomberg, Standard Chartered Research
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Chart 2: Euro-area periphery stock markets sag Stock indices seen the October 2007 peak
150 S&P_US (Oct 5 '07=100) DAX_Germany (Oct 5 '07=100) IBEX_Spain (Oct 5 '07=100) MIB_Italy (Oct 5 '07=100) ASE_Greece (Oct 5 '07 =100)

Greece gov't bond 5Y Ireland gov't bond 5Y German gov't bond 5Y

Italy Gov't bond 5Y Portuguese gov't bond 5Y

100

50

0 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Sources: Bloomberg, Standard Chartered Research
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There is still a possibility that contagion will not return. If Italy and Spain could inspire more confidence in policy and generate a real improvement in the coming months, markets might calm down. But it is hard to be optimistic given the scale of the problems and the difficulty of generating stronger economic growth, especially in a climate of uncertainty. Meanwhile, the risk of a backlash from taxpayers in Germany, the Netherlands, Finland and elsewhere remains. Is some form of global bail-out possible? The US and UK are both very concerned about the European crisis and it is a threat to China and the rest of the world too. So perhaps more funds to supplement the EFSF could be put up by the IMF, the US or even China, which might at least avoid Germanys difficult choice for now. One problem is that the IMF is always regarded as a preferred creditor even though it is not formally senior; the US and China might demand seniority too. This means that investors would continue to see lending as risky and the markets would likely not re-open until countries could substantially improve the debt outlook. The question remains: Can countries restore growth and reduce debt burdens, or will their lack of competitiveness together with political pressures as austerity fatigue mounts get in the way?

Italy is the key

If the crisis returns, Italian borrowing costs may well rise to unmanageable levels, while funding for Italian banks both foreign lines and domestic depositors will decline. Eventually, the only way out may be either for countries to ask for a rescheduling of debt or to re-establish their own currencies. Reverting to individual currencies would imply a default, since governments would likely repay the debt in their new currency, which might be worth 70% of the EUR at best, and more likely only 30-50%. The size of the Italian economy and debt means that a default would be a huge shock to the European banking system. Spain and the other peripheral countries would likely go the same way, adding to the problems. A default without leaving the EUR is likely to be countries first choice as we already see with Greece. The question is whether this will be enough to restore economic growth in the long run, without a major improvement in competitiveness too. In principle, weaker countries could re-establish individual currencies through a collective effort from northern countries and the ECB to make the transition relatively smooth. It could be accompanied by promises that the rift is only temporary and countries will return to the shared currency (at a lower exchange rate) before too long. Chart 3: The debt and deficit spectrum Net debt versus underlying primary balance 2011
140 General government net debt interest payment % JP IT US IR PU FR CA NZ -10 SP AU 0 BE GE GR 120 100 80 60 40 20 0

Chart 4: Government finances out of line Total government outlays and total receipts 2011
Total tax and non-tax receipts % 55 50 IT 45 40 35 30 30 35 40 45 Total outlays % 50 55 60 SW US SP JP GE IPA IR GR UK FR

UK

-8 -6 -4 -2 General government underlying primary balances %

Sources: OECD, Standard Chartered Research

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Sources: OECD, Standard Chartered Research

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In practice, the likely fast pace of the unfolding collapse, together with political differences and anger about who is to blame, may make this difficult to achieve. Departures from the EUR would create considerable market uncertainty, with worries about how many countries might leave and even whether the EUR might be abandoned altogether. The EUR would inevitably decline sharply against other currencies. Markets will also be concerned if the European single market, the centre-piece of the modern EU, is itself under threat. It would be important therefore that, despite what would undoubtedly be a tense, chaotic process, Germany and France held together in emphasizing that EUR exits are a step back for European integration, not the end of the process. We fully expect that the EUR would continue, even if it was reduced to a rump of countries centred around Germany and France.

Impact on the rest of the world

A Greek default is a relatively minor shock in world terms. Even a Greek departure from the EUR would not be a disaster. The problem is, and always has been, contagion. If Spain and especially Italy face default or leave the EUR, the shock would be huge. Just as Lehman Brothers was allowed to fail because, given the political environment, the US government judged it was too big to save, so the same could happen with Italy unless it can fully restore market faith. The situation remains dangerous. We hope that any wider shock will not happen at all, or will come later, when the world recovery is on stronger ground and financial institutions have increased their capital. The key channels are financial, trade and confidence The three main channels for transmitting the shock of default or EUR exit to other countries are the financial sector, trade and business confidence. European countries would be most affected, including the UK. Losses among banks and other financial institutions might require further injections of government capital in some cases. But financial institutions are already effectively back-stopped by their sovereigns, so there is no problem unless people begin to doubt the strength of sovereign debt. The potential losses do not appear to be large enough for this. European economic growth would take a knock too, because of the initial uncertainty, though this might be partly offset by weaker currencies versus the US dollar (USD) and Asia and lower oil prices. Devaluation by some countries would hurt the others. Outside Europe, the US would be affected. The impact on business confidence should be less serious than in 2008-09 as well. The second time around, the shock effect should be lower, while banks and central banks will likely make sure that credit, including trade credit, are maintained. Lower US bond yields and lower oil prices should help sentiment too. More QE in the US is possible too. Overall, we would not expect a euro-area split (even including Italy) to be as damaging as the Lehman crisis. Although likely to be much less severe than the 2008-09 financial crisis, this outcome will surely mean a new slowdown, at least for a time. Lower asset prices as risk positions are reduced and disruption in the European economy all point this way.

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Impact on emerging countries

Emerging countries would inevitably be hit by another world slowdown, but Asian countries are relatively well-insulated A recession in Europe would dent emerging-country exports, especially if the US slowed significantly too. The risks of financial problems are limited by the generally low exposure of Asian financial institutions to European banks (just as we saw this channel limited after the US financial crisis). The confidence channel is important, however. A fall in world stock markets and risks assets generally would have a negative effect on Asia. It might not be all bad, since many countries are still trying to cool over-heating economies. We continue to see Asia as relatively well-insulated, given its high underlying growth potential, large FX reserves and strong financial systems.

US may test market tolerance

Across the Atlantic, the markets have, so far, remained relaxed about the US fiscal negotiations. Indeed, US borrowing costs have gone down because of the euro-area crisis. The latest press reports suggest that a substantial deficit-reduction deal is on the table, worth about USD 3trn over the next 10 years. Moreover, it reportedly includes major spending cuts, and tax and process reform. But details are still sketchy and the US political process is unpredictable. If this deal falls through, anxiety will rise. The apparent willingness of some members of the Republican Party to risk even a temporary default is worrisome. If it does come to late payments, or even runs close, considerable damage would be done to the US reputation. Also, the negotiations have focussed attention on the size of the adjustment needed in the US. The package under discussion is large, but still may not be enough. If it falls through, a smaller package might be agreed which would be a disappointment to the markets, possibly triggering a rating downgrade. The next major window for adjustment in the US is not likely until after the presidential elections next year. Even though the US deficit and debt are higher than the total euro-area position, the US situation is less worrying. The euro area is only as strong as its weakest (large) member. Italian debt is higher than US debt, Italy cannot devalue (at least while it is part of the single-currency system) and we have more faith in the long-term ability of the US to adjust and to grow. But the US will need to prove that it can adjust in coming years. Its deficit is far worse than Italys, and, if this is not corrected over the next two to four years, the debt ratios will move up to Italian levels in a few years. The rating agencies would withdraw the AAA rating long before this happened. Chart 5: US real borrowing costs are low Borrowing rates less core inflation
6 5 4 3 2 1 0 -1 -2 -3 Jan-00 Jul-01 Jan-03 Jul-04 3mth Treasury yield (subtract PCE core y/y) Jan-06 Jul-07 Jan-09 Jul-10 10Y Treasury yield (subtract PCE core y/y)

Chart 6: US and UK devaluation helps BIS real effective exchange rates

110 105 100 95 90 85 80 75 70 Feb-03 Feb-05 Feb-07 Feb-09 Feb-11 UK US Japan Italy

Sources: Bloomberg, Standard Chartered Research

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Sources: Bloomberg, Standard Chartered Research

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Japan still gets away with it

Just how much longer markets will be relaxed about Japans debt remains to be seen Japans net government debt, estimated at 127% of GDP at end-2011, has risen from 81% in 2007, before the crisis, leaving it second only to Greece. Just how much longer markets will be relaxed about this high level remains to be seen. Most of government debt is held by domestic investors, which lowers the risk of a sudden exodus. But Japans long-term debt dynamics are problematic given the declining working population and low rate of productivity growth. Nominal interest rates are very low, but real rates are not so low given the deflationary environment. So far, Japan shows no sign of seriously tackling the deficit. The earthquake tragedy has made the deficit worse in the short term.

The UK tries to adjust, but growth is weak

Meanwhile, unlike Italy and the other euro-are periphery countries, which left adjustment until far too late; and the US and Japan, which are still putting it off; the UK has embarked on a multi-year austerity programme before markets demanded it. Early indications are that economic growth is struggling to retain traction, despite near-zero interest rates, an expanded Bank of England balance sheet owing to quantitative easing last year, and an exchange rate running 20% below the level of 2003-07. But it is still very early in the process to judge results, and the economy has been hit by higher oil and food prices this year. We are optimistic that the devaluation will provide the basis for a successful adjustment.

The adjustment process

It is dangerous to leave adjustment until too late
Once markets lose confidence, there is a kind of reverse bubble or market crash Government debt has long been high in several developed countries, including Japan, Italy and Belgium. Yet, the borrowing premium, if any, was not large enough to add a significant extra burden. So, debt sustainability was viewed as a long-term issue, with the focus on trends in the deficit, the growth outlook and fiscal reforms. But the succession of euro-area periphery countries which have seen a sudden sharp rise in borrowing costs shows what can happen if markets begin to lose faith in a countrys willingness and ability to service debt. Rising interest rates make the debt burden look unsustainable, so rates may rise even higher. It is a form of reverse bubble or market crash. Investors fear that if others are not willing to buy new or rolled-over debt, then the government could be forced to default. In retrospect, markets may have overlooked the risks, believing that various tail-risk probabilities, like the worst recession since WWII or a major weakening of the banking system, could be safely ignored. Perhaps markets were overly optimistic that governments would respond effectively. In Europe there has also been a widely held view that, since the EUR was clearly a political project more than a logical economic step, governments would be prepared to move forward to fiscal and even political union, if necessary. This view is still widely held but is open to serious doubt.

Fixed exchange rates aggravate the problem

Membership in the EUR severely aggravates the problem, as do all fixed exchangerate systems. This was the lesson from debt crises in the past, from Latin America in the early 1980s (starting with Chile in 1981) through Asia in 1997. Fixed exchange rates (or quasi-fixed in some cases) exacerbate a credit boom and allow imbalances to build up. Then, when growth slumps, there is no safety valve to restore competitiveness and create a little inflation. A devaluation is eventually forced, but proves disruptive because many have borrowed in foreign currency.
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If Greece and others in the euro area are eventually forced to abandon the EUR, it will be very difficult for governments to service their debt in EUR; most likely it will simply be redenominated in the new currency (an effective default to the holder). But some financial institutions and commercial borrowers may find that they are locked into EUR-denominated debt and so will face distress. Eventually, devaluation paves the way for an economic recovery (provided it does not lead to an inflation/devaluation spiral), as Asia showed in 1998-09 and Argentina in 2003 onwards, but it takes time.

Greeces first choice is to default rather than exit the EUR

The short-term costs of abandoning the EUR would be high, while the benefits would likely arrive only when the next set of politicians is in place When countries are using a fixedexchange-rate system and cannot adjust, they may prefer to default and not devalue as we see with Greece. The costs of leaving the EUR are high, especially in the short term. Governments will try to resist abandoning the currency since they know that it will be seen as a major policy failure, and the benefits are likely to come through only when different politicians are in place. Investors are aware of this preference, which is why doubts about fiscal sustainability in euro-area countries have shown up quickly in market yields. In contrast, for a country without a fixed exchange rate that is beginning to look fiscally unsound, the first result will be a weaker exchange rate, as we have seen in the US and UK over recent years, encouraged by easy monetary policy. Bond yields may rise too, but the fear is primarily inflation and devaluation rather than default, so financing costs tend to edge rather than rocket up. Having said that, fiscal sustainability doubts can also feed on themselves in a floating regime. Even a 50bps extra borrowing premium makes the fiscal picture less sustainable in the long run, by raising the interest burden and slowing economic growth. So far, there is no sign of this in the US, UK or Japan. A study by Carmen Reinhart and Ken Rogoff analysing past sovereign-debt crises found that countries with a debt ratio above 90% tended to have slower growth than countries with lower ratios. But correlation does not prove causality. Countries with slow growth often struggle to prevent their debt ratio from rising, as we have seen with Japan over the last two decades. Even if causality is accepted, the study does not mean that growth is fine up to a debt ratio of 89% of GDP and then slows. In fact, it appears that lower debt is generally associated with higher growth and vice-versa, across a whole range of debt levels.

Sovereign debt is critical for the banking system

Higher sovereign yields hit banks and by extension weaken the economy Worries about government debt make life difficult for banks for four reasons, five in the case of euro-area countries. First, banks naturally hold significant amounts of their own sovereigns paper in their portfolios. Indeed, since the 2008 crisis, most banks have increased their holdings of government paper, partly out of choice and partly reflecting the increased regulatory focus on maintaining a strong liquidity position. Second, banks are the biggest users of long-term debt, which tends to be priced off the sovereign yield. So, long-term borrowing costs have been rising for banks in the euro-area periphery countries, putting pressure on their balance sheets and/or being passed on to borrowers. Non-financial companies have to pay more for issuing securities, too, but they are not usually such big borrowers. Also, a crisis usually affects their balance sheets and profit outlook less than for banks (though depending on their borrowings and business they are affected to varying degrees as well, a factor which tends to hurt investment and growth).
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Third, large banks benefit from an implicit sovereign guarantee, at least to some extent. The guarantee has been explicit in many countries since 2008, though in theory it is slowly being withdrawn. But if doubts emerge about the fiscal sustainability of the sovereign, then bank borrowing costs naturally rise. Bank stocks fall too, making new equity harder to raise. Stock markets in all the euro-area periphery countries have been falling in recent weeks, led down by banks, and are still well below their 2007 highs, in contrast to Germany and the US. As last weeks bank stress tests revealed, many banks in Europe (not just those that failed) are sparsely capitalised and not well-insulated from a major recession or upset, which is far more likely if the sovereign is in trouble. Fourth, difficulties for banks and doubts about sovereign backing reduce interbank funding. Banks in Greece, Ireland, Portugal and to some extent Spain have faced difficulty in obtaining overnight or other very short-term funding from international banks for some time. They have had to resort to borrowing from the ECB, making the ECB itself very uncomfortable. Italy may now face the same problem, so ECB lending there is likely to rise very quickly. The fifth problem, which faces euro-area banks only, is that if depositors begin to question the commitment to remaining in the single currency, they will move money out to banks in Germany, Switzerland, Luxembourg or other havens. Most of it will stay in EUR, so there is no exchange-rate implication, in contrast to old-fashioned capital flight from emerging countries. But this outflow reduces the funding available to banks and forces them further into the arms of the ECB. Not surprisingly, most banks are likely to respond by reducing their balance sheets, which implies less credit and money in their economies. The euro area no longer publishes money supply on a country basis, on the argument that it is not meaningful in a single currency area. However, since country banking systems are still largely separate and, in any case, outside banks are unlikely to be actively lending into the periphery countries in the current environment, the drop in money and credit aggregates is a drag on the economy.

Austerity, growth, inflation or default

There are only four ways to reduce sovereign debt, though most countries will use more than one There are four ways to reduce a sovereign-debt burden, though more than one can be, and may need to be, used. The exact combination that countries use will vary. And while any country, fixed exchange rate or not, can try the austerity or default options, the inflation option is not available within the euro area and the growth route may be more difficult.

Austerity
Austerity means raising taxes and/or cutting spending. Research is clear that fiscal adjustments in the past have usually worked better when the balance is heavily towards cutting spending. However, this may partly reflect the fact that countries with fiscal crises in the past have usually already had a relatively high tax take from GDP. Both Japan and the US have long taken only about 30-33% of GDP in total tax revenues, much lower than in Europe or Canada, so a case could be made that there is more room for tax increases in those countries. However both theory and practice also suggest that higher taxes do slow a economy by reducing work incentives. This can be mitigated by focussing on taxes on spending (VAT and duties etc), and reducing income tax exemptions rather than raising rates. But this is often hard to do politically. In Britain, top tax rates were raised sharply by the outgoing Labour government and the coalition has felt unable to reduce them.
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Where there is less agreement is on the extent to which fiscal tightening slows economic growth in the short term via the Keynesian demand route. Keynesians, particularly prominent in the US, argue that, just as a fiscal stimulus can be expected to boost growth temporarily, fiscal contraction has the opposite effect. Others argue, that the so-called fiscal multiplier is small, or even negative in some countries. Moreover, since tighter fiscal policy improves private-sector confidence, it can therefore encourage economic growth, despite its direct effect on aggregate demand. This latter view is widely held in the US on the political Right, but among policy makers is more common in Europe. Easy monetary policy can offset tight fiscal policy In our view, the key is the balance of fiscal and monetary policy. There are plenty of examples historically in which fiscal contraction has not brought weak growth, but this always seems to be because monetary policy was loosened simultaneously (lower interest rates and a lower exchange rate). In the 1930s, for example, the UK government ignored Keynes and tightened fiscal policy aggressively. But Britain almost simultaneously left the gold standard, which enabled it to cut interest rates and devalue. The economy grew strongly in the following years and unemployment steadily fell. The UK repeated this pattern in both the early 1980s and the early 1990s, as did Canada in the mid-1990s. The key is that while fiscal policy was tightened sharply, interest rates were simultaneously lowered and currencies allowed to depreciate, helping to boost economic growth. However, with interest rates already very low, there is no room for further cuts. There is also uncertainty about the effectiveness of unconventional monetary policy such as quantitative easing (QE). In this authors view, QE works and can be an effective offset to tightening fiscal policy. QE in Japan from 2001-05 was followed by Japans strongest burst of growth for more than a decade and deflation eased. QE seems also to have worked in the US and UK in 2009-11 in supporting recovery. In all these cases, the effects worked through higher asset prices and a weaker exchange rate, exactly as would be expected in the transmission of an easy monetary policy. But it is impossible to be sure of the importance of QE in generating these recoveries versus other factors such as a natural cyclical bounce or faster growth elsewhere. We have only limited experience and this assessment is controversial. A key problem for countries remaining in the euro area is that there is absolutely no possibility of independently easing monetary policy or devaluing. Indeed, as already noted, the outflow of funding for the banking system tends to reduce both monetary and credit aggregates and monetary policy is effectively tightened. Even low interest rates may not be low in real terms, if tight fiscal policy brings deflation, as is possible and may even be necessary if they are to regain lost competitiveness.

Growth
Strong growth makes countries both more able and more willing to service debt Economic growth works to lower debt ratios by increasing the denominator (i.e., GDP). Of course governments need to contain the numerator (debt) too by reducing the deficit. But growth indirectly works to alleviate debt crises by creating employment and income growth, which ensures that the population is content to keep servicing debt. It also makes markets believe that the debt is more likely to be fully serviced, creating a virtuous circle as interest spreads or premia come down, improving fiscal sustainability.

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The key to generating faster economic growth is a combination of reforms and investment. The most important reforms are usually tariff reduction, labour market reforms, measures to heighten product competition and privatisation. Reforms sometimes hit investment in the short term as businesses must realign to the new realities. More often though, over time, they generate new opportunities and new enthusiasm. Some economists also put considerable emphasis on Keynes idea of animal spirits, the need for business to feel optimistic and willing to take risks on new investments. Fiscal crises are an opportunity for reform since, in the midst of crisis, governments and people often accept the need for radical change. Business as usual just wont do. But exactly how it plays out in each country depends on political developments. A new government with a strong mandate can sometimes achieve major change. A weak government or one that is perceived as partly to blame for the crisis may face more difficulty. Sometimes too, measures to control the fiscal deficit may go against reform and investment for example, higher tax rates or reduced government infrastructure investment.

Inflation
Arranging for inflation to erode debt burdens is harder than sometimes supposed, though it would work for EUR members if they exited Under certain circumstances, inflation can help to improve debt ratios. But this depends on the country having a relatively long maturity of debt and then generating unexpected inflation. If the inflation is expected, it will already be priced into higher bond yields. The success of this strategy also depends on the response of the central bank. If the central bank reacts to higher inflation by quickly raising short rates, shortterm funding costs will rise, as will long-term bond yields. The government may be able to pay off its longer term debt over time in devalued money, but its funding for new debt will limit the gain. If the central bank is slow to raise rates, either because it judges that inflation will not persist or because it is not independent, then the debt ratio will come down faster. In our view, euro-area countries could relatively quickly improve their debt ratios by devaluing and inflating. This would come at the expense of debt holders both domestic and foreign. Since so much debt in euro-area countries is held by foreigners (50-70% in most of the problem countries) this option may appear attractive to voters. On the negative side, the hit to foreigners would naturally cause some ructions. Greece, for example, receives an estimated EUR 5bn annually in EU grants and subsidised loans which might be at risk. Moreover, as noted above, leaving the EUR is not likely to be the first choice for politicians because the costs are front-loaded. The extent of the improvement in debt depends on how much a country devalues and, indeed whether it can quickly regain control of money. The Argentine peso (ARS) devalued initially by about 75% in 2002, before recovering slightly to about a 67% decline. Indonesia saw a similar devaluation after the Asian crisis. If Greece followed the same trajectory, it could push its government debt down to 50% (from 150%) in a matter of months, though it might also need to inject more capital into the banking system. For the US, inflation is a much less sure route to improved debt ratios. Currently, interest rates are extremely low, with 10Y UST yields under 3% and bill rates at nearly zero. But the average maturity of debt is relatively short at about five years. So unless inflation rises rapidly and significantly, it is hard to make a dent in the
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debt ratio. An IMF study found that five years of inflation at 6% p.a. versus an expected 2% rate would cut the US debt to GDP ratio by only about 9ppt at the end of the period (IMF, February 2010 Strategies for Fiscal Consolidation in the PostCrisis World). In fact, creating a sudden burst of inflation of this magnitude would be quite difficult. It is much easier to imagine a degree of inflation creep; for example, inching up to 3% and then perhaps 4% over several years, rather than a sudden leap. But this would have only a small effect in reducing debt.

Default
Default is not an attractive option for countries that still have a net new borrowing requirement Default is usually not so much a strategy as a last resort. As already noted, if foreigners take much of the hit, the domestic political and economic costs are lower, though there may be other implications. One of the major problems with default is that it usually prevents new borrowing, at least for a while. For countries which still have a net borrowing requirement (like Greece now) this forces a rapid adjustment and may add to the pain. It is partly for this reason that we expected Greece to avoid any hint of default until 2013-14, by which time it should have reduced its borrowing requirement. Indeed, this seems to have been the strategy at least until recently, but Germany insisted on forcing a default. Fortunately for Greece, new finance is still being provided. The long-term results of default also depend very much on policy after this. If the country still follows poor policies, including undisciplined fiscal policy, lack of structural reform and poor monetary policy, then the economy may still struggle to do well and the international credit markets may stay closed. If, in contrast, the country follows a textbook adjustment programme it will likely quickly achieve strong economic growth and renewed access to the markets. Of course, since it is the failure to follow a sound adjustment policy in the first place that leads to default, such an outcome is unusual.

Country by country outlook

Greece Default and very possibly inflation via EUR exit
The choice for Greece is between default inside the euro area or leaving the EUR and repaying in its replacement currency Greece is now certain to default, but the debt reduction agreed at the 21 July summit is still not enough to restore debt sustainability. It might reduce the debt-toGDP ratio from about 170% at its projected peak next year to 130% at best. Further haircuts are likely to be necessary (including losses for northern taxpayers and the ECB) with an eventual total loss unlikely to be less than 50% of original face value. This is already priced into the markets. There is also a significant possibility that eventually Greece will leave the EUR and improve its debt ratio via the inflation route. We do not see economic growth as providing much of a solution for Greeces indebtedness unless Greece leaves the EUR. Greeces lack of competitiveness as well as the stress of deflation will make investment hard to come by. Austerity, however, will have to play a continuing role; Greece still has a significant net borrowing requirement.

Ireland Austerity and growth could work, given time

We have much more faith that Ireland has the wealth and political strength to successfully implement austerity measures, and the economic flexibility to regain good economic growth in due course. However there is still a significant risk of default on some of the debt assumed from banks. If Greece alone eventually leaves the EUR, Ireland is unlikely to be forced to follow. However, if several countries end up leaving the EUR, it might be difficult for Ireland to avoid the same fate (though not impossible).
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Time is a critical factor for Ireland. If any further contagion to Mediterranean countries can be delayed to 2013 or later, Ireland may be able to move out of intensive care by then, avoiding both a chaotic default and EUR exit.

Italy Low deficit means austerity might be enough

We give Italy a high chance of using austerity to control its debt. This is not because we are especially positive about the political process there. Indeed, we are not. But the austerity requirement for Italy is actually quite modest, far less than for Greece or Ireland for example, and Italy is a rich country. Italys budget deficit is estimated at 3.9% of GDP this year, before the latest measures, compared with 7.5% for Greece and 10.1% for Ireland. Now that contagion has spread to Italy, we see a good chance that Italians will rouse themselves and deal with the problem. The budget measures passed last week are a good start. But more measures will be essential in coming months if contagion is to be contained enough to allow Italian borrowing costs to subside to more comfortable levels. We are not optimistic, however, that Italy will be able to generate significant economic growth to escape its debt problems; this could still undermine the adjustment in the long run. Economic growth has been lacklustre throughout the last decade (GDP growth averaged only 1.2% from 2003-07), despite low borrowing costs and a favourable world environment. Also, we anticipate that while the political will may be there to push through austerity measures, structural adjustment measures will be harder to achieve. Two weeks ago we would have given only a small probability to the likelihood of an Italian default or devaluation. But, with Germanys reluctance to move ahead of events demonstrated once again, we fear that the situation could easily spin out of control. It is true that Italy has a relatively long debt maturity profile, which potentially allows time for rescue arrangements to be agreed. Even so, Italys size probably means that it is too big for Germany to save. It is down to the Italians to solve the problem.

Japan The outlook is murky

At present, there seems no obvious way that Japan will escape from an inexorably increasing debt burden. Yet, while it may not have reached its limits, given the predominantly domestic sources of financing, the steady rise in debt cannot go on forever. An early attempt to impose austerity in 1997, via raising consumption taxes, is widely thought to have choked off growth at that time, though the Asian crisis was also a factor. Still, a new rise in consumption taxes is on the agenda and we do see this as part of the debt-improvement process. Japans overall tax burden is modest compared with other developed countries. The prospect of growth playing much of a role seems bleak. The labour force is declining and productivity growth is low, despite still relatively high investment. Major structural change (such as freeing up the service and retail sectors) still seems hard to achieve. Readers may be surprised that we ascribe a medium likelihood to inflation as part of the solution, despite Japan currently suffering from deflation. We think that Japan will eventually suffer a crisis of confidence in economic management which will take the form of an exchange-rate decline, perhaps coupled with a political crisis. We see the outcome as a much more expansionary monetary policy. With the average debt yield so low currently, a period of inflation of 4-5% could play a
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significant role in reducing the debt burden. However, this is admittedly a somewhat speculative scenario; others might argue that the increasingly elderly population will strongly resist higher inflation. We struggle to see any other way out.

Portugal Hostage to contagion from Greece

We judge Portugal to be likely to follow in Greeces footsteps, even though its debt position is less severe. The prospects for generating economic growth seem limited, after a lacklustre decade. In the absence of a general euro-area crisis, Portugal might have been able to carry on with a large debt burden and slow growth for some time. But it is likely to be carried along with other countries.

Spain Austerity and growth could save the day

In contrast, we judge Spain as likely to be able to use both austerity and growth to good effect. The debt ratios are still well below US and UK levels, which gives Spain time to adjust. For example, the gross debt-to-GDP ratio at end-2010 was 66% in Spain versus 82% in the UK and 94% in the US. The budget deficit is projected at about 6% this year compared with 8% in the UK and 10% in the US. One big negative is the ongoing recession in the construction sector and associated financial stress, with many observers worried that the full effects are still to come. The other is membership in the euro area. We rate inflation and default as possible primarily because of the risk of contagion from other countries. Not so much contagion from Greece, because Spain is not in nearly as weak a position as Greece; but rather, contagion from Italy or a decision that the future of the EUR lies in the weaker countries leaving for a time.

UK On track via austerity and growth

The UK has already embarked on an austerity programme, with roughly threequarters of the fiscal adjustment coming in spending cuts. There appears to be widespread acceptance of this programme, perhaps helped by the coalition nature of the government. Acceptance is also helped by recognition of the need for spending cuts. The proportion of spending in GDP rose by 6.9ppt between 2007 and 2010, well above the OECD average of 4.5%. However, some studies suggest that the governments existing programme does not go far enough and more austerity will be needed in later years. The prospect for improving debt ratios via economic growth also looks good. The British pound (GBP) has devalued significantly (about 20% in real trade-weighted terms) which should be enough to support stronger growth, without generating a permanent inflation spiral. The Bank of England stands ready to implement more QE if necessary. The British economy is one of the most flexible economies in the world, making it well able to adapt. Moves to improve the structure of the economy, such as cutting marginal tax rates and speeding the development planning process would help, but the UK seems well placed to make the adjustment given time.

US Austerity needed but fundamental dynamism will help

Approaching the 2 August deadline, the outcome of the budget negotiations remains uncertain, as is typical of the US political system. Over the medium to long term, we are confident that the US will control spending. The proportion of spending in GDP rose by 5.4ppt in the US during 2007-10, but even more important is the current projected surge in entitlement spending in future years. Most observers believe that
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an increase in taxation will also be required over the medium run, with the US tax share in GDP one of the lowest in the OECD area and, over recent years, 2-3ppt below 1990s levels. But Republicans are adamantly against tax increases and Democrats are anxious to defend spending. Last years mid-term congressional elections sent a strong message that people want the budget fixed, but the politics appear unusually polarised. We are hopeful of a large package being agreed over the next week or two. If not, the next chance for a full assault on the problem will likely come in 2013 after the presidential elections. Either Barack Obama will be re-elected and, as a second-term president, have an incentive to fix the problem to secure his place in the history books, or, a Republican will be elected and will likely pursue fiscal virtue forcefully (though the recent run of Republican presidents have not been particularly good at this). The US is very conscious of its declining relative status in the world and most Americans make a direct connection between the need to solve the budget problem and national strength and pride. We are optimistic that the adjustment in the US will also benefit from strong growth over time. Near-term, we still see the aftermath of the housing bubble as holding growth back, but this should dissipate over time. Then we expect the superior dynamism of the US economy to once again shine through, supported by relatively good demographic prospects from immigration (in comparison to Europe and Japan). As already noted, inflation is unlikely to play a significant role in controlling debt. The Feds five-year forward breakeven inflation rate (calculated from the TIPs yield curve) currently forecasts inflation of about 3% in five years time. This is higher than today and above the Feds informal 2% target, and could be about right. But it will not help much with reducing the debt burden.

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Disclosures Appendix
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John Calverley Global Head of Macroeconomic Research

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20:45 GMT 22 July 2011

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