Submitted by Gu?nter Leitold
Will bond investors and savers have to hold forced government loans at some point in the future?
Numerous governments of developed countries are likely to fail when trying to liquidate their large debt burdens in an orderly way. Japan, for example, steadily widened its debt load over the past 22 years and thereby constructed the largest bankruptcy waiting to happen. Since 1990, new borrowings and interest payments were the biggest contributors to build up the Japanese state of pre-insolvency. While Japanese government bond yields have been around 2.6% p.a. on average, these yields were still 2% above nominal GDP growth of just 0.6%.
The chance of not being able to de-leverage is dangerously high when the free market requires a nation to pay interest rates significantly above its nominal growth rate. The nations of the European periphery, Portugal, Spain, Italy and Ireland currently overpay nominal growth rates in the long term bond market by 11,01%, 5.84%, 5.09% and 4.38% respectively. They are directly heading towards the need of a restructuring while Greece has a good chance of requiring a second one.
Nominal interest rates set around 1% - 2% below nominal growth rates for a significant period of time would be needed to help these countries to leave the debt build-up course behind. This change of interest rates would erase mark-to-market losses on sovereign bond positions for the semi-solvent banking sector, but it would also wipe out the carry and leave them without earning power on this part of the balance sheet. However, some of them would still need to restructure. Keeping the high government interest rates in place will lead to some spectacular restructurings in the future.
I assume if central planners decide to circumvent the already manipulated bond market and enforce much lower interest rates by implementing forced loans, there would be a big uproar for some time in the market. However, the negative wealth effect on the private sector would be more foreseeable and stretched out over a longer period of time. This definitely would decrease uncertainty. In my opinion, this measure would actually help to break through the downward spiral and avoid the much more devastating course towards a restructuring event with its negative side effects.
Everyone and their dog realizes that suffering the whole pain of a restructuring event at once is a bad alternative compared to spreading the pain over a longer period of time and spreading it in an orderly and less uncertain way.
It seems that the free market does not provide this option without harsh government intervention. The free market tends towards capital flight, wider risk spreads and thereby makes a restructuring event at the end of the road more likely. Greece for that matter has been half-solved at best and therefore has a good chance of being back on the brink soon.
I believe that at some point, we may see the implementation of a temporary regime which includes forced government loans for domestic private sector participants paired with strict capital controls for as long as the de-leveraging is going on.
This scenario however assumes a discontinuation of the belief or hope, that the private sector of stronger borrower nations (like Germany) will be able and/or willing to help to consume a private sector wealth haircut for other nations or the belief or hope that debt problems will somehow disappear, which never happened so far as I know.
At the moment politicians of countries with a tense financial situation might not like the idea of implementing such a regime now. Even if they agree in doing these measures, they may want to change the name from forced or compulsory loans (which have been used in the past to finance wars) to something nicer like "solidarity bonds".
Even Japan and/or the US may have to change to such a regime as soon as the marginal buyer of their bonds turns to a seller and/or some capital flight starts. This could occur after further rating downgrades paired with decreasing effects of their continued money printing efforts.
A regime like this would make sense until certain de-leveraging targets are achieved. Such targets could be expressed as debt to GDP and/or interest expense to total expenses. The targets should certainly include the frequently hidden government debt components like local government and agency debt, unfunded debt components, guarantees etc. Contrariwise the subtraction of certain eligible assets like cash, marketable securities, etc. should be permitted.
To guarantee that such financial repressions are not circumvented by the private sector too easily, these measures would have to be paired with temporary capital controls. Every domestic private sector participant (financial institutions, corporations, non-profit organisations, etc.) would have to subscribe to these "solidarity bonds" on a pro-rata basis related to the financial wealth (including gold and some other "inflation hedged" assets). Special wealth tax treatment might be imposed for those which fail to be in compliance with their subscription in the forced bond exchange.
The implementation may be easiest achieved by a tough regulation of all domestic financial institutions (banks, insurance companies, fund managers, pension funds, etc.). Banks would then f.i. have to hold a certain share of their client deposits in such bonds and accordingly pay a slightly reduced rate on customer deposits.
It is hard to predict which government policies are likely to be imposed in the future. Politicians, who are already unable to cope with the situation, may at first find it hard to take that route. However, from today’s point of view the sovereign debt situation will further deteriorate which increases the likelihood of a restructuring event. Harsh measures to exit the downward spiral and growing reluctance to pay high free market rates will make forced loans a more likely scenario.
This option may also be less damaging to politicians compared to tax increases, austerity measures, direct wealth taxes, more bail-outs and money printing. All this measures will continue to show that they have little effect on the construction of a successful de-leveraging process, while in the absence of significant growth, low cost funding is needed. If growth picks up, yields would automatically turn from negative to positive levels.
I believe that people will find many reasons why this can not be done. Critics will point out that this government funding scheme will be a direct toll on private wealth in order to liquidate government debt. There may be some unintended consequences like some people wanting to take all their money under the mattress, or an increase in non- financial asset purchases. However, the net effect would be significantly less damaging than the sudden stop of funding when a restructuring becomes expected combined with a massive uncertainly when a de-leveraging episode is needed but not executed.
Personally, I would hate to see some 30% of my financial assets directly or indirectly invested in such negative yielding bonds for about 7 to 10 years, but it may be worth paying this price in order to avoid the other devastating road some high income nations are currently on. The net present value of the other 70% of the portfolio would help to compensate for that.