The Macro View: Politics sustain sovereign risks

The worst recession since World War II is over. But the recovery is fragile and there are serious risks of setbacks. All the major economies expect to register positive growth in 2010 (see table below), in sharp contrast to the big GDP falls recorded in 2009. The rising status of the BRICs (Brazil, Russia, India and China) symbolises the shift in global power towards the emerging economies, which this recession has accentuated. Russia’s economy fell sharply in 2009, but India and China continued to expand rapidly during the global downturn while Brazil escaped with a negligible fall.

The recession has obscured inter-country differences. But the current feeble recovery highlights concerns over sovereign risk and forces investors to adopt a discriminatory stance. Extreme measures, while ensuring recession did not turn into a disastrous depression, have left a messy legacy that can only be cleaned up at considerable political costs. Greece is only willing to retrench at a pace its eurozone partners, notably Germany, regard as inadequate. Greece may be weak but it is by no means clear that it will blink first in the current confrontation. Since neither a break-up of the euro nor an unconditional bailout is a palatable option at present, both sides have patched up an uneasy compromise that has averted a major crisis. But the situation remains unstable.

British Beef
With a budget deficit totalling 12 percent of GDP, the UK faces budgetary problems that are superficially similar to those of Greece. But its outstanding debt is lower than in most European countries. Since the maturity of UK debt is very long, there is less pressure to go to the market to rollover existing debt. Most significantly, since sterling is outside the eurozone, the UK retains a vital safety valve. If it loses international competitiveness, sterling would fall but it would avoid economic decline. Faced with the same problem, eurozone members without the flexibility of their own currency would face unpalatable choices: cut wages to restore competitiveness, or accept rising unemployment and decline.

The UK has real strengths and has so far retained its cherished AAA credit rating. But confidence in the UK has declined and sterling has dropped sharply recently. Speculation that a hung parliament after the General Election will lead to instability and paralysis has triggered attacks against sterling.

UK politicians are paying lip service to cutting the deficit, but current plans are not sufficiently detailed. The markets are questioning the political will to restore fiscal stability. Given the economy’s weakness, it is impossible to cut spending immediately. But too many spending areas cannot be touched. If the UK fails to present a truly credible plan after the election it risks losing its AAA status.

Though a large and rich economy, Europe’s weight is shrinking, not only in relation to Asia but also against the US. Eurozone growth was slower than that of the US during the boom years, its decline was steeper in the recession and the underperformance continues in the early stages of recovery. In the fourth quarter of 2009, US GDP expanded by an impressive annualised rate of 5.9 percent, much stronger than the anaemic 0.3 percent (annualised) in Europe, or the 1.1 percent (annualised) in the UK.

Recent US dollar strength against the euro and sterling signals an important change in market behaviour. In 2009, the dollar was a haven currency, rising during periods of risk aversion and weakening when share prices rose and risk appetite was high. But in 2010, the dollar recorded net gains in spite of continued increases in share prices. Europe’s predicament now supports the dollar.

But even the mighty US will not be immune indefinitely to sovereign risk fears over lack of political will to restore fiscal stability. Persistent US job losses, though smaller than feared, will inevitably exert pressures for protectionism and other harmful populist measures.

Withdrawal
For the central banks, the most urgent issues relate to their exit strategies – when to start withdrawing the huge stimulus and how aggressively to do so. Since risks of double-dip recession persist, even in the US, the central banks are retaining their main policies. But they are no longer adding to the stimulus and are gradually removing secondary features. For example, the Federal Reserve raised the discount rate from 0.5 percent to 0.75 percent, while stressing that the key Fed funds rate will stay at 0-0.25 percent for an extended period. The forecasts suggest the main policy rates will start edging up in the third quarter of 2010, with the pace of tightening becoming more pronounced.