Elephants in the Room
Friday, September 9, 2021
With the rise in inflation, the natural course is to expect a rise in overall interest rates. However, with an increase in sovereign debt over the past decade, an increase in rates in some cases is not just painful, but unbearable. For example, in the case of Italy, which carries a debt to GDP ratio of 156%, a 100-basis point increase in funding costs for the country’s EUR2.75 trillion debt would push its annual deficit from EUR160B to EUR187B and its interest expense as a percentage of tax revenues would be 39%. Bear in mind, in the US, the 10-year Treasury rates exceeded 15% as of 1981, compared to the current 1.25%. While many believe that taxes could always be raised to fill the gap, at some point, the gap becomes too great. Arguably, the case of Japan is even more acute as debt to GDP is a sobering 256%. While currently, the modestly negative short-term yields in Japan are rewarding the country for its indebtedness, one has to question whether the current situation is sustainable. Perhaps a better question is how it is being sustained currently.
Rabbits in the Hat
Normally capital markets are fairly efficient at rewarding the productive and punishing the unproductive. However, some external forces have come into play over the past decade which has led to what some might view as distortions. In particular, the central banks have become active in markets and have used their balance sheets in an effort to stabilize the markets. To assist nations in bridging shortfalls in demand during times of economic stress, luminaries such as the economist Keynes had encouraged such intervention. Ex-FED chair Ben Bernanke, a scholar of the Great Depression, further endorsed such actions suggesting he would drop money from helicopters during time of stress in an effort to stimulate demand (hence the sobriquet “Helicopter Ben”).
While all that is fine, what about the current situation whereby nations cannot afford even a modest rise in rates. Our view is that when a problem is too large to be solved, it simply will not be solved. In the case of Italy, watch for a continuation of issuance of the EU-based bonds with Italy being the primary beneficiary under the rubric of “covid-related relief”. For those paying attention, there has been a sea change whereby the EU is effectively accepting a mutualization of EU nations’ debt and the stronger nations such as Germany are supporting the weaker nations such as the Southern European members. Meanwhile, ECB purchases continue to keep Italian interest rates reasonable.
While a bailout by the EU and ECB might work for Italy, what about Japan?; where will it find its savior? From our perspective, there are several alternatives:
First, there has been a massive change in the geopolitics in Asia whereby the Western nations are now relying on Japan to a far greater extent than normal to prevent actions from China in the South China sea. It is not unreasonable for Japan to be paid for its efforts which might have the effect of moderating its indebtedness.
Second, as has been the case in the past, the IMF could assist Japan by allowing special drawing rights (SDRs) which allow nations to benefit from an increase in the value of gold held by the IMF for various nations.
Third, Japan, in concert with other indebted nations might execute an accounting sleight of hand whereby the treasury holdings of the central bank might be placed in an off-balance sheet long-term account to be forgiven over time in exchange for some structural improvements which is likely to be viewed as a fig leaf of an excuse, but an excuse none the less.
Now for the contrary view. While the above plans appear to be elegant, like war, rarely do things proceed as planned. Mr. Soros made a fortune in 1992 by betting against the Bank of England in the Bank’s ill-fated venture of defending the pound. Any entity puts itself at the whim of the markets when it becomes over-extended. Hence fortune favors the prepared.
Thinking the Unthinkable
Whether most people realize it or not, in the past month, the world has dramatically changed. In particular, the takeover of Afghanistan by a religious, radical regime has dramatically altered the balance of power in central Asia. Furthermore, two of the superpowers, Russia and the US, have been found to be powerless in imposing their will on Afghanistan, with both withdrawing after expending considerable sums in money and lives. What was particularly telling was that many in nuclear-enabled Pakistan cheered the outcome, expressing support for the Taliban. Our fear is that the radicalized Taliban will secure more dangerous weapons than the small arms they previously possessed and use those to further their cause. On the anniversary of the 9/11 disaster, there should be little doubt regarding the motivations, resourcefulness nor ingenuity of Taliban members in striking. The difference now is possible access to far more dangerous weaponry. Furthermore, continued tensions between Pakistan and India complicate matters.
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