With sovereign CDS (and risk) finally becoming a heated topic of debate, Moody's has compiled its 2009 Review and 2010 Theme Review for sovereigns. The report opens with some rather stark and reasonable observations: "2010 may prove to be a tumultuous year for sovereign debt issuers given the uncertainties surrounding the likely pace and intensity of fiscal and monetary 'exit strategies' as governments start to unwind quantitative easing programs. Indeed, the only certainty is that the exit strategies will be fraught with a good deal of execution risk. In our view, the key policy challenge facing advanced economies is therefore to time the exit perfectly: not too quickly or too soon so as to prevent choking off growth; and not too slowly or too late so as not to unsettle financial markets." In short: 2010 will be the year when the experiment of offloading all private sector risk on the public balance sheet ends. Whether the conclusion will be a happy or sad one, remains to be seen.
A summary of Moody's key themes:
- As the global economic recovery attains a more solid footing, 2010 will at best see a "normalization"and at worst a severe tightening in government financing conditions. Long-term interest rates may increase more rapidly than expected because of an over-reaction to economic news, which we believe will be mildly positive overall. Moreover, the slow unwinding of "quantitative easing" will accelerate this credit repricing process.
- The end of exceptionally low financing conditions will expose the true cost of the crisis on government debt affordability across the world.
- Aaa governments will probably not have the luxury of waiting for the recovery to be secured before announcing and perhaps also implementing credible fiscal consolidation programs.
- As most governments simply cannot afford another financial crisis, they will attempt to ring-fence their balance sheets from selected contingent liabilities. This could in some cases create disorderly market conditions.
- EMU membership will protect some countries against liquidity risk but not against long-term insolvency risk.
- Despite a slow process of global sovereign risk convergence – i.e. a narrowing of the ratings gap between rich and poorer G20 countries – BRIC countries are unlikely to replace the large Aaas’ role as anchors to the system any time soon.
- The crisis has once again revealed the dangers of financial globalization for emerging markets – namely, the upside of the recurrence of asset price inflation after the downside of precipitous outflows of capital. However, the arsenal of policy levers has not expanded.
Below is a summary of who did how in terms of their Moody's rating in 2009. The worst performers: Latvia, Lithuania, Japan, Iceland, and... no, not the US or UK, despite skyrocketing deficits, but Fiji and Jamaica instead. Score one for the frontal lobotomy machine.
Moody's ten core themes in more detail:
- Aaa countries will probably not have the luxury of waiting for the recovery to be secured before announcing credible fiscal consolidation plans.
- The “growth versus adjustment” debate is artificial: advanced economies will need as much adjustment as necessary, and as much growth as possible.
- For countries operating at sharply lower output levels and with reduced growth potential, the debt equation will look increasingly complicated.
- Most governments cannot afford another financial crisis. Attempting to ring-fence balance sheets from
contingent liabilities will keep policy makers busy.
- Very large public debt and low economic vitality will prompt unprecedented questions about how governments can discharge their obligations without changing the rules of the game.
- EMU participation protects against liquidity risk but not against long-term insolvency.
- The dangers of a rapid and debt-fuelled income convergence process will lead to renewed emphasis on total country debt.
- Global sovereign risk convergence is at play, but only slowly.
- While the crisis has confirmed the dangers of financial globalization for emerging markets, the arsenal of policy levers has not expanded.
- Debt hang-hover will test social and political cohesiveness.
Full report for much more detail.