Britain's debtor weaknesses
Update: PIMCO has announced that it will be a net seller of UK bonds this year. The European portfolio manager is Andrew Balls, brother of UK government minister Ed Balls, so one wonders what the siblings may have to tell each other.
This week's Spectator includes an article by Irwin Stelzer, a noted economic commentator, entitled "Who would lend to a bankrupt Britain?"
Stelzer's comments follow recent developments in the market for "credit default swaps" (CDS) - insurance contracts that pay out if a business or government defaults on its debt. The premium (price) of the insurance reflects the degree of concern, and in the case of the UK, that concern has deepened.
CMA DataVision supplies information on the CDS market. Its third-quarter report on sovereign (national) debt assesses each country for the chances of a default within the next five years (CPD, or "Cumulative Probability of Default"), the cost of default insurance and what that means about creditworthiness. In this report (see page 14), the UK is rated as having a 4% CPD, with an implied credit rating at "aa+".
The top "aaa" credit rating is enjoyed by the USA, Australia and a small handful of European countries including ourselves, but things have moved on and it looks as though we are heading for a downgrading. The CMA report linked above covered the market for CDS contracts between July and September. On 7 December, the average CDS risk premium for the UK reportedly increased to 0.74% p.a. (85% higher than in the third quarter), which compares very unfavourably with the USA's premium at 0.32% p.a. This insurance repricing suggests that the UK's risk of default within 5 years may have risen to around 5.5%.
Are we going broke? Not yet, but our economy is not as strong as it used to be, and this is reflected in the price of gilts (government bonds, or Treasury securities). Gilts offer a fixed income for a fixed period, but can be bought and sold many times before their maturity date. Factors influencing their price include interest rates available elsewhere and the chance of default.
If gilts become cheaper, their fixed income is higher in comparison. The relationship of income to the traded price is called the "yield" - effectively, an interest rate. Immediately after British Chancellor Alistair Darling delivered his Pre-Budget Report to Parliament on 9 December, 10-year gilt prices fell and their yield rose from 3.81% to 3.85%.
The bond markets are, so to speak, the judges on Strictly Come Borrowing, and they are not impressed by the proposals they have seen. This, not bankruptcy, is the implication of CDS premiums, gilt yields and national credit ratings: we can expect to pay more for access to extra funds.
Since we are already so indebted, personally and nationally, an increase in interest rates will add to our burdens, at the same time that (in a recession) profits and tax revenues are decreasing; so Britain could have to borrow even more just to keep going. Spiralling debt and the growing reluctance of lenders could eventually force us to call in the International Monetary Fund as a lender of last resort, which we last did in 1976. That was bitter medicine, but still better than what would happen if we defaulted altogether and credit markets shunned us completely (or imposed loan-shark rates and terms).
However, we are very far from the worst case globally. The same third-quarter report by CMA DataVision named three countries that had a five-year default risk of over 50%: the Ukraine, Venezuela and Argentina. The annual CDS risk premiums for the first two were 12% and 11.25% respectively; both have since increased to over 13% per annum. Closer to home, Ireland's risk premium is 1.55%, Greece's 2%, , Lithuania's 3.2% and Iceland's 4.4%.
Although the USA is still regarded as a safe borrower, individual States are not: California's annual CDS premium is about 2.5%, reflecting an estimated 20% risk of default within 5 years.
British banks themselves now have a significant CDS premium, ranging from about 0.9% p.a. for Barclays to 1.4% p.a. for the Royal Bank of Scotland - the latter implies about a 10% risk of defaulting within 5 years.
So, no panic yet, but grounds for considerable concern.
Derivatives: a bigger worry?
A second worry is the state of credit default swaps themselves, and other "derivatives". The total amounts insured in this hard-to-understand market are vast, much bigger than any country's GDP. The USA's GDP is something like $14 trillion, but the CDS market is worth about $36 trillion - down from $62 trillion in 2008.
The derivatives market as a whole is much larger - an estimated $1,400 trillion in April 2009, many times the entire world's annual GDP. It's a mammoth global insurance/betting game, and if a major player comes unstuck it could destabilise finance, just as the collapse of Lehman Brothers and others threatened to do not long ago.
We think of insurance as reducing risk, but actually it's about transferring risk. Promises can turn out to be very expensive: the world's oldest mutual insurer, Equitable Life, suffered a major crisis because of a guarantee it made regarding minimum annuity rates for some of its pension investors; Barings, the oldest merchant bank in London, was destroyed by derivatives traded by its employee Nick Leeson.
The derivatives market is huge, interconnected and inadequately regulated. It is the fourth threat identified by Michael Panzner in his prescient book, "Financial Armageddon," which I reviewed in May 2007. Let us hope that this one can be neutralized in time.
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