II. Implications of Fiscal Developments for Government Debt Markets
- International Monetary Fund. Fiscal Affairs Dept.
- Published Date:
- May 2010
A. Financing Needs
13. Government financing needs remain exceptionally high in most advanced economies. This year, aggregate gross financing needs—defined as the new overall borrowing requirement, plus debt maturing during the year—will exceed 60 percent of GDP for Japan and reach 20 percent or more in many other advanced economies, including several in Europe, plus Canada and the United States (Table 6). Given relatively short average debt maturities—5½ years on average for advanced economies—and significant expected deficits, financing needs will remain high in the years to come.
14. By contrast, financing needs remain more moderate among emerging and low-income economies.
In emerging economies, debt ratios on average declined before the crisis, while lengthening maturities also helped create fiscal space for some countries (e.g., Brazil, Malaysia, Peru, and Turkey) and limit rollover needs. The median aggregate gross financing requirement for a group of 49 emerging economies was 6½ to 7½ percent of GDP during 2004–2008. It rose to 11 percent of GDP in 2009 but is projected to decline to 9 percent in 2010. Some economies are expected to experience significant increases in funding needs in 2010 relative to historic levels (Figure 6), including some with relatively moderate debt levels but increasing debt and credit risk spreads since 2007 (e.g., Latvia, Lithuania). Others, including some with relatively high public debt levels (e.g., Brazil, the Philippines) have projected financing needs that are in line with or below their historical averages.
In low-income economies, financing needs are manageable but require stepped-up efforts to access foreign financing. During the crisis, low-income country governments resorted to domestic sources to finance larger deficits and protect pro-growth spending. As growth resumes, access to more diversified financing sources would be helpful to avoid putting pressure on interest rates and crowding out private investment. Access to concessional financing remains particularly important in economies with higher debt distress risk; low-income economies with stronger fiscal positions are likely to resume precrisis efforts to tap capital markets to finance deficits.
Figure 6.Emerging Economies: Financing Requirements in 2010 and Deviations from Past Averages
Sources: April 2010 WEO for deficit and debt; and IMF staff estimates for amortization.
Note: The size of the bubble reflects the debt-to-GDP ratio prior to the crisis.
15. The supply of government securities will also be affected by the eventual unwinding of large positions taken by some central banks. The largest purchases were made by the Bank of England, which since mid-2008 has acquired gilts in excess of 14 percent of GDP (Table 7), more than a fifth of the outstanding gross debt of the general government of the United Kingdom. Purchases of government securities were part of an array of extraordinary emergency operations motivated by monetary policy objectives, namely the continued expansion of liquidity when the policy interest rate reached levels close to its zero bound and many financial markets had seized up.8 As liquidity conditions and interest rates return gradually to more normal levels, central banks can be expected to unwind these operations and further increase the supply of government securities (or central bank instruments) in the market.
16. Since mid-2009, average government debt maturities have shortened. At the height of the crisis in 2008–09, a spike in risk aversion prompted strong demand for sovereign debt, primarily at the short-end of the yield curve. This led to increased issuance of short-term debt instruments to maintain adequate supply at that maturity. In some cases, the maturity shortening may have also reflected actual or anticipated difficulties in placing longer-term bonds, or cost considerations.9 Notably, since the summer of 2009, average maturity declined in many advanced economies (the exception being Australia, Ireland, Italy, Norway, Slovenia, the United States), resulting in a weighted average shortening by 1.2 months.
B. Government Bond Yields and Spreads10
17. Yields on government securities in most advanced economies remain relatively low, but spreads have risen sharply in some countries, reflecting concerns about the fiscal outlook. Over the course of 2009, government bond yields in most advanced economies increased from record lows reached at the beginning of the year. This reflected a pickup of economic activity, a dissipation of deflation risks, and a stabilization of financial market sentiment. Yields generally remain low, as monetary conditions continue to be relaxed and private sector activity weak (Figure 7). However, concerns about fiscal developments had led recently to a surge in yields in Greece, Portugal and Ireland, and to a lesser extent Spain, triggered, to varying degrees across these countries, by downgrades and limited success in rolling over debt (Figure 8). In the immediate aftermath of the announcement on May 10 of a package of measures adopted by the EU and the ECB to address financial market pressures, yields declined substantially.
Figure 7.Bond Yields and EMBI Spread
Sources: DataStream for bond yields (10-year maturity) and Bloomberg (EMBI).
Figure 8.Bond Yields in Selected Euro Area Economies
Source: DataStream (10-year maturity).
18. Other indicators of the risk attached to investing in government securities in advanced economies also remain relatively muted, except in a handful of countries. Relative asset swap (RAS) spreads—measuring the difference between benchmark government bond yields and the fixed-rate arm of an interest rate swap in the same currency and of the same maturity (usually 10 years) as the bond—confirm the heightened concern over sovereign fiscal positions in Greece, Portugal, and Ireland, and to a lesser extent for Spain (Figure 9). RAS spreads are quite low for other countries, although they have recently become positive for the United Kingdom. CDS spreads have been more volatile than bond yields and RAS spreads since the inception of the crisis, probably due to the more limited size of the market (Figure 10).11 This said, evidence suggests the CDS market has led the pickup in bond yields in the recent episodes in Greece and Portugal.12
Figure 9.Relative Asset Swap (RAS) Spreads
Figure 10.Sovereign CDS Spreads: Advanced vs. Emerging and G-7 Economies
Source: DataStream and IMF staff calculations.
Note: For Canada sovereign CDS spread data were not available.
19. Yields and spreads have evolved favorably for emerging economies in recent months. With increased risk appetite and an associated search for yields, demand for emerging economy sovereign debt rose sharply, leading to shrinking emerging market spreads. The changing perception of sovereign risk is also reflected in a divergence of CDS spreads between advanced and emerging economies.
20. Fiscal-financial sector linkages also continue to affect risk perceptions. As evidenced by several episodes during 2008–09, sovereign risk premiums increased sharply following financial sector distress events, as weak financial institutions can trigger implicit and explicit fiscal obligations. Conversely, sovereign credit problems could affect the financial sector on the asset side, if falling sovereign debt prices increase losses on bank holdings of sovereign debt and downgrades weaken their capital positions. Recent BIS data show that financial sector exposure to this risk has increased.13 There could also be negative effects through the liability side, to the extent that bank wholesale funding costs rise in tandem with increasing sovereign funding costs. Furthermore, the weakening financial position of sovereigns may reduce the perceived value of sovereign guarantees to the banking system.14
The ECB announced on May 10, 2010 that it will conduct interventions in the euro area public and private debt securities markets.
The United Kingdom stands out with an exceptionally long maturity, reflecting in part a deliberate strategy to lengthen maturities and facilitated by the size of its financial system (including large pension and insurance industries). However, some economies with large debt ratios, such as Japan, have relatively short average maturities.
Data for yields and spreads reported in this section are up to May 11, 2010.
The sovereign risk reallocated via CDS markets remains contained compared to the total amount of debt outstanding. Net CDS positions amount to only about 5 percent of outstanding government debt in Portugal (the country with the highest share), 4 percent in Ireland, and 2 percent in Greece and Spain. In other countries, including Italy, the ratio is even lower, and it is extremely small for Japan, the United Kingdom, and the United States. Net CDS positions are obtained as the sum of the net protection bought by net buyers (or equivalently net protection sold by net sellers); the source is the Depository Trust & Clearing Corporation. Debt levels and exchange rates are from the April 2010 WEO.
The analysis uses 5-year CDS and 10-year bonds, as they are the most liquid maturities. Granger causality tests over the period January 2008-April 2010 show that the CDS spreads anticipated bond spreads (measured by the Relative Asset Swap spreads), while the reverse is not true.
Data from the BIS Consolidated Banking Statistics (April 2010) show that the foreign claims of BIS reporting banks on the public sector as a share of total consolidated foreign claims has increased in each of the last eight quarters (up to the fourth quarter of 2009), from about 14 percent to almost 19 percent. Higher holdings of the debt of the United States and of various European governments account for most of the expansion.
See Chapter I, Section B, of the Global Financial Stability Report (April 2010) for an extensive analysis of how financial channels can amplify sovereign risk.