2012: The Year of Debt Restructuring

Over the next twelve months, expect unsettling developments. The global crisis is still unfolding, and it could escalate. Weakening growth, rising systemic risks, and contagion-prone markets are likely to enhance economic and financial fragility. We are entering a perilous new phase.

First, growth will remain below potential, hindered by excessive debt.  Since 2000, total world dues – the debt globally held by governments, corporations, and households – doubled (from 32 to 63 percent of global output), mostly in developed economies. This rise fuelled international growth for more than a decade but now, to avoid a structural deceleration of global activity, the balance is due.  In other words, public and household balance sheets are overstretched by excess leverage. Deleveraging, essential to return to pre-crisis levels of per-capita income, will weaken growth.

In 2012, the world economy is expected to grow at a frail 3 percent. Advanced economies face anemic prospects. Fiscal austerity – underway in Europe and much-needed in the US – and a credit crunch due to tighter bank lending will curb the recovery.

Europe will undergo a “double-dip” recession, short-lived in the core, France and Germany, and deeper in the Mediterranean periphery. Amid a deteriorating growth outlook, the sovereign debt crisis that began in Greece and spread to Ireland, Portugal, Italy and Spain will press on. Greece will default. Italy’s rising bond yields (now at 6 – 7 percent) will amplify fiscal challenges. France will lose its AAA status, and Germany might follow. The European Central Bank (ECB) has made clear that it will not rescue any government before shared fiscal rules and competitiveness-restoring reforms are agreed upon and approved. Quantitative easing (QE) is unlikely in the near term. Recession and deflation will prove costly ways to achieve relative devaluation. EU rescue vehicles (EFSF and ESM) will fall short: €1 trillion is needed and not readily available. The banking sector is fragile. Further stress could come from private sector involvement (PSI) – i.e. voluntary sovereign debt restructuring – in Portugal. Direct exposure to peripheral sovereign bonds will entail capital losses. Greek PSI has already bankrupted Dexia and – probably – Commerzbank. An orderly adjustment is the base case scenario, but disorderly developments (Italy and Spain losing market access, additional sovereign defaults, banks runs, and EZ breakup) are possible.

In the US, despite fiscal and monetary expansion (deficit at 9 percent, benchmark interest rate at 0.25 percent) and a positive business outlook, the economy is unlikely to grow above 2 percent, muddling-through at below potential levels. To sustain growth, incomes need to improve, but unemployment is structurally high and a quarter of mortgages are above house value. At $60 trillion, the net present value of future liabilities (social security, Medicare, Medicaid) is eroding the dollar’s “reserve currency” status. A gridlocked political environment will weaken the recovery, limiting the administration’s ability to approve a medium-term fiscal consolidation plan aiming at public debt sustainability while injecting additional fiscal stimulus. Policies in support of the labor and housing markets (i.e. extension of payroll tax cuts and unemployment benefits, Obama’s job-creation plan) might face headwinds. A European banking crisis is likely to impair US credit supply and, in case of major bank failure, induce a recession. Further downgrades are possible if – after the failure of the “debt-reduction Super Committee” – the $1.2 trillion automatic budget cuts were to be suspended.

Emerging markets (EM) will grow at about 6 percent, and for the first time will purchase more than half the world’s imports. Still, given their trade and financial links with the developed world, EM will suffer the global slowdown, especially if Europe’s strains were to worsen further. Lower EU and US demand will reduce export growth and commodity prices. A pullback in lending by European banks will make EM borrowing harder and more expensive. Asia will play a key role in sustaining world growth, but will not reverse the ongoing deceleration. Currency depreciation and capital flight will pose intertwined risks, and enhance volatility. China, in a year of leadership change, will aim at strengthening its safety net – via social housing and healthcare spending – and household income. Because of the ongoing correction in property prices, developers will suffer. Non-performing loans will rise and the financial system will need recapitalization. As real estate investment accounts for about 13 per cent of GDP, government revenues will decline. Still, if growth were to weaken significantly, Beijing is likely to loosen its prudent monetary policy and increase fiscal expenditures.

Second, downside risks are rising: too many issues remain unresolved, and policy is out of steam. The massive stimuli – fiscal injections, interest rate reductions, QE – that kick-started the recovery in 2009 are to be progressively withdrawn. Across the Atlantic, policy makers will be forced to address structural economic issues, but the political process will delay difficult decisions. Global demand could be weakened further by negative feedback-loops between high debt, fragile sovereigns and banks, fewer jobs and social grievances, insufficient rebalancing, higher uncertainty and lower confidence. Over the course of the year, a few negative shocks are to be expected.

To clean up balance sheets, debt needs to be paid down or restructured. Political and economic considerations will determine who will pay.  The private sector will face tax increases. Workers will suffer high unemployment and declining wages. In absence of sustained growth, creditors will face debt-restructuring, a wealth transfer to their debtors. In the EU, Germany will have to forgive peripheral-debt and guarantee central government debt of core countries. In the US, negative-equity mortgages will need to be written-down.

Banks are likely to maintain high liquidity, tight lending, and suffer a rise in non-performing loans. The Euro Zone will suffer financial instability and banking sector stress. The risks of sovereign default and bank bankruptcy are rising. Banks need to recapitalize and – to reach a 9 percent Tier-1 ratio – will shrink their balance sheet. As private capital is unlikely to show appetite, government-takeovers or partial nationalization are in the cards. As a result, the US banking industry might suffer contagion and credit disruptions. Still, the US will continue to benefit from deep bond markets and credible liquidity conditions. Central banks will support the financial system if conditions worsen.

In Eastern Europe, high levels of external debt are coupled with current account and fiscal deficits. Lending came mostly from Austria and other core European countries, via a large bank exposure. If foreign investors lose confidence, capital will be withdrawn and currencies will come under pressure. With depreciation, imports will become more expensive and relative costs rise. The central bank would sell reserves to buy the domestic currency, attracting speculators. Default – or debt-restructuring – would ensue. Hungary already asked for IMF financial support.

Rising social grievances will be left unanswered. Massive protests at the global level are likely to persist, fuelled by unemployment, budget cuts, and high food prices. In the Middle East, evolution is unlikely to replace revolution. Worryingly, financial markets might not allow time for individual nations to work through the political process.

Third, global markets will operate in a jittery landscape. Europe’s challenges will keep investors worried. Italy could become the largest source of contagion. Concerns about sovereign debt and banks’ balance sheets, widespread downgrades of earnings and credit ratings, rising systemic risks and elevated correlations will restrain financial flows and spark periodical sell-off of risky assets. The strong corporate sector’s financial position and the weakness of the economy will favor mergers and acquisitions (M&A). In bond and equity markets, a “home bias” will persist. US Treasuries will remain a refuge, with yields at 2 percent or below. If further stimuli measures do not get enacted, equity performance will suffer economic stagnation, underperforming bonds. Alas, policy makers will not be able to supply the same amount of liquidity they provided in late-2008. As inflation will continue to ease globally, central banks will indeed cut rates, but will not significantly grow the monetary base. Budget constraints and political impasse will hamper fiscal expansion. In the EU, the ECB will walk the fine line between moral hazard (printing money and buying bonds would lift pro-reform pressures from the periphery) and financial instability (markets dislike unsustainable rises in bond yields). Article 123 of the Lisbon Treaty, also known as the “no bail out clause”, forbids the ECB to print Euros in order to be the lender of last resort. In the US, further QE is possible, with the Fed creating more money to buy financial assets, but the policy has become controversial, as it is unclear that previous rounds could lift the real economy.

Against this backdrop, where to invest? Capital preservation and prudent risk management are priorities. Deflationary pressures (due to unused capacity in goods and labor markets), high downside risks and a fragile upside will push investors into cash. Also, cash allows taking advantage of both low valuations and the volatility inherent to a highly liquid post-crisis environment. However, in the medium-term holding liquidity will not pay off. Cash and bond investments will see their purchasing power eroded by inflation. Indeed, negative real interest rates will produce massive transfers from those who play safe (depositors and lenders) to risk-prone investors (borrowers). A sustained equity rally is possible, but would depend on clear and decisive public policies. In Europe, the ECB should backstop sovereign bonds, and governments provide an unambiguous map towards the introduction of Eurobonds. In the US, the approval of the stimulus bill is essential to uplift growth. In China, fiscal expansion, monetary easing, and currency appreciation would need to tackle current account imbalances.

4 Responses to "2012: The Year of Debt Restructuring"

  1. AdityaJayaram   December 19, 2011 at 11:43 am

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  2. DiranM   December 20, 2011 at 2:18 pm

    I have never been warm on Eurobonds. It seems to me just another financial scam for more improperly priced credit and ever more debt stock that got the Euroweenies into their current mess in the first place. What is really needed is a sharp reduction of debt stock and proper credit pricing for each country on its capacity to service the debt. That deeply upsets the over fed and incompetent Euroweenies in Brussels who run the Eurozone circus.

    As Draghi correctly pointed out today, there needs to be a central fiscal authority that the bondholders can look to for repayment. The concept of cosigning using say a German signature to cover for an EZ credit deadbeat country is a lousy one, truly worthy of Euroweenie politicos with larceny in their hearts and the usual urges to screw one another, etc….

    Why would a self respecting country serious about its national sovereignty want to accept EU taxation and defer to these Brussels Eurocrats, who have already proved to be so incompetent as well as larcenous, etc.

    Serious countries have their own national currencies and central banks!!! A serious people want to be free and stand on their own two feet, rather than free loading and living off others.