Capital Flows

The difference between Greek and German government bond yields can be used to estimate the market’s view of the likelihood of a Greek default. The chart above shows these probabilities over different time frames on three different dates. On April 30th, no European plan was yet in place to address the ballooning Greek debt, and default was considered a real possibility in the short term. On May 11th, just after the European Stabilization Mechanism (ESM) was announced, markets sharply cut their view on the odds of default across all time horizons. However, the market’s analysis of the ESM has become much more nuanced since then. On September 1st, the market’s view of the probability of default within two years was lower than before the ESM was announced, but higher over longer time frames. Greece will happily borrow from the ESM to avoid having to close its primary deficit (that is, excluding interest payments) too rapidly. Yet if Greece is successful in eliminating its primary deficit, its temptation to default will actually grow, as it can wipe out huge amounts of accumulated debt without any longer needing the financial markets to fund current expenditures. If faced with the choice between paying Greek debts and letting Greece default, its northern neighbors may, once their banks are on more solid footing, find it more attractive simply to let Greece default. This is the story line that the markets are now pricing into government bond spreads. Davis: IMF Warns Countries of Debt Risks, Dismisses Idea of Greek Default Harding: Greece Debt Default Seen as ‘Unlikely’ Economist: An Uneasy Calm Economist: Greece's Reforms

Foreign ownership of U.S. assets, particularly Treasury bonds, has increased significantly over the last two decades. Foreigners now own 57% of outstanding U.S. Treasurys, up from 37% in 1997. The chart above shows that this growth has been driven entirely by government purchases, notably China’s. In the two years ending in March 2005, official sector purchases accounted for 60% of new issuance, compared to about 40% historically back to 1960. The increasing significance of government participants, whose motivations are not always profit-driven, may help to explain Alan Greenspan’s famous “conundrum” — the question of why long-term interest rates declined in the face of strong economic conditions and rising short-term rates in late 2004 and early 2005. This disruption to the mechanism through which monetary policy normally affects the broader economy may one day work in reverse if governments choose to reduce their exposure to Treasurys back to 1960s levels. The resulting “reverse conundrum” — rising long-term interest rates in the face of weak economic conditions and falling short rates — would be far more unpleasant than the Greenspan version. Warnock: How Dangerous Is U.S. Government Debt? CGS Chart Book: Foreign Ownership of U.S. Assets Steil, Swartz: Dangers of U.S. Debt in Foreign Hands Greenspan: FRB's Monetary Policy Report

In his recently published memoir, former Treasury Secretary Henry Paulson claims that Russian officials approached the Chinese in the summer of 2008 suggesting that both countries sell large amounts of debt issued by U.S. Government-Sponsored Enterprises (GSEs), such as Fannie Mae and Freddie Mac, in order to pressure the United States into explicitly backing these companies. Paulson, who found the report “deeply troubling,” claims that China opted not to collaborate with Russia. Nonetheless, both countries dumped GSE debt that summer, as illustrated in the figure above. Russia sold $170 billion during 2008, while China sold nearly $50 billion between June 2008, when its holdings peaked, and the end of 2008. During this fire sale the yield spread between GSE debt and U.S. Treasury debt soared, as illustrated in the figure below. As GSE debt was widely used as collateral in the U.S. repo market, U.S. financial institutions were obliged to quickly pony up more securities to support their borrowing. This exacerbated the growing credit crunch. The U.S. government was forced to put the GSEs into conservatorship in September 2008. Secretary Paulson was more right than he realized to be concerned. The episode highlighted the clear risks to the United States, and indeed the wider world, of growing American dependence on foreign government lending. Steil, Swartz: Dangers of U.S. Debt in Foreign Hands Setser: Sovereign Wealth and Sovereign Power Setser: Central Banks Aren’t Always a Stabilizing Presence in the Market McKee, Nicholson: Paulson Says Russia Urged China to Dump Fannie, Freddie Bonds

Greece’s 2009 budget deficit was 13.6% of GDP. The primary deficit – the balance before interest – was 8.5% of GDP. The main difference between the total deficit and the primary deficit is the ‘snowball effect,’ or the effect through time of low growth and high interest rates on the debt to GDP ratio. As shown in the figure above, the snowball effect replaces the primary deficit as the principal driver of Greece’s spiraling debt ratio in 2010 and 2011. New loans from the IMF and European Union may avert default in the short term, but do not change this debt dynamic. According to the European Commission, which optimistically assumes that Greece achieves 1.2% GDP growth and pays an average interest rate of 4.7% in 2011, Greece needs to achieve a primary surplus of nearly 5% of GDP in order to stop the upward march of indebtedness. This is a massive mountain for Greece to climb to avoid default. But consider also that once Greece achieves a primary surplus of any size it actually has an enormous incentive to default, as it can then wipe out huge amounts of accumulated debts without any longer needing the financial markets to fund current expenditures. In short, a Greek default is almost certainly a matter of ‘when’ rather than ‘if.’ Wolf: Governments Up the Stakes in Their Fight With Markets Buiter: Sovereign Debt Problems to Continue Gros: Tough Love for Eurozone Levinson: Reforming the Eurozone

Before the creation of the euro, European governments borrowed at very different rates. In July 1995, Portugal, Italy, Greece, and Spain all had to pay at least 4% more than Germany on their borrowings. This spread was in large part driven by differences in the market’s inflation expectations. As the market became increasingly confident that these countries would join the euro, this spread narrowed. As shown in the chart, by the time the various national currencies were pegged to the euro the spread was nearly gone. During the second half of 2008 the spread returned. This time, the demand for higher returns does not reflect a fear of higher inflation, but rather the view that these countries are much more likely than Germany to default. Mallaby: Leaving the Euro Behind? Wolverson: The Risk of Greek Contagion Kupchan: Crisis for Europe in Greek Debt? Levinson: Muddling through Greece's Tremors

On April 26th, Standard and Poor’s downgraded Greece’s credit rating, and Greek sovereign credit default swaps (CDS) climbed to 825 basis points - far higher than before the IMF and European Council of Ministers announced a support package. The Greek crisis is clearly unresolved. Some have argued that if Greece had never switched from the drachma to the euro it would have been able to pursue a fiscal policy that fit its domestic needs without depending on international capital markets. Yet Greece consistently relied on non-drachma debt issuance well before it adopted the euro in 2001. In the six years before joining the euro, only 27% of Greek debt was issued in drachma. At the end of 2000, just before Greece joined the eurozone, 79% of its outstanding debt was already denominated in euros, and a mere 8% in drachmas. Even if Greece had remained outside the eurozone, its dependence on euro borrowing would only have increased. A falling drachma would merely have brought the current crisis to a head earlier by accelerating the rise in Greece's debt-to-GDP ratio (think Iceland). The fact that the euro is not an "optimum currency" for Greece, or any other eurozone country for that matter, is not the main problem. That problem is excessive foreign borrowing, a problem with which Greece has struggled since the early 19th century. Steil: Don't Blame the Euro for Greece's Woes Economist: Bailing Out Greece FT: Greek Bonds

An investment portfolio reveals the risk preference of its owner. The graph above summarizes the foreign portfolio distribution of six large developed economies. The top half shows each country’s holdings of foreign assets, while the bottom half shows assets held by foreigners. The U.S. is the dominant financial risk taker, holding more than twice the proportion of equity held by the other major economies. America’s equity-heavy portfolio led to a significant deterioration in its net international investment position when world equity markets collapsed in 2008, and a significant recovery in 2009. The relatively high volatility in U.S. external wealth can be expected to continue in the coming years.

News that global trade contracted in 2009 underscores the need for Obama’s trade strategy to include negotiating exchange rates with Asian countries and promoting free trade agreements, says IIE’s Gary Hufbauer.

The Federal Reserve plans to stop buying securities issued by government housing loan agencies Fannie Mae and Freddie Mac by the end of the first quarter. This is not only likely to push up mortgage rates; Treasury rates should rise as well. Throughout 2009, the private sector sold a portion of their agency holdings to the Fed and used those funds to buy Treasurys. Once the Fed’s agency purchases stop, this private sector portfolio shift will end, removing a major source of demand in the Treasury market. As the chart shows, since the start of 2009 the Fed has bought or financed the entire increase in Treasury issuance. As Fed purchases slow and Treasury issuance continues at a high level, interest rates will have to move up to attract new buyers. FOMC: Statement from December 16, 2009 Gross: Let’s Get Fisical

The U.S. is increasing its military and civilian presence in Afghanistan as part of the Obama administration’s efforts to bring stability to the region and reduce the threat of terrorism at home. Economic growth is critical for building a stable society in a war-torn country. Although Afghanistan’s economy has grown by 20 percent annually since 2002, this growth has largely been driven by foreign aid. Aid has risen by 25 percent annually since 2002, increasing from 32 percent of GDP in 2002 to 42 percent in 2008. These massive aid inflows have fueled corruption, and leave the economy exposed to destabilizing shocks once aid is withdrawn. Building a functional, self-sustaining Afghan economy is therefore vital to the success of the U.S. and coalition mission in the country. Woodward: Key in Afghanistan-Economy, Not Military Cockburn: Kabul's New Elite Live High on West's Largesse CRS: Afghanistan: U.S. Foreign Assistance

Fitch Ratings downgrade of Greek government debt has raised concerns about sovereign default risk. Within the Eurozone these concerns are particularly relevant because countries cannot print money to buy their own debt. These charts demonstrate a strong link between high deficits and high credit default swap spreads (CDS) - the market’s view of sovereign risk - and a very weak link between CDS spreads and overall debt levels. For example, although Ireland’s debt level is lower than Italy’s, Ireland, with a higher deficit, has a larger CDS spread. Investors fear deficits more than debt levels because deficits test the market’s willingness to finance a deteriorating balance sheet, while high but stable debt levels do not. Related Links Mallaby: A Bad Omen In Dubai Economist: Risk After Dubai Slater, Blackstone, Walker: Countries' Debt Woes Pose Risk to Upturn

Global imbalances, as reflected in the current account deficits and surpluses of the world’s major regions, fell with the collapse of trade and oil prices in 2008, but should rise again as both recover. This chart shows that global imbalances are driven primarily by the U.S. and China. Absent significant macroeconomic policy changes in one or both, the likelihood of a sustained, significant improvement in global imbalances, without another crisis, is small. Dunaway: The U.S.-China Economic Relationship Dunaway: Global Imbalances and the Financial Crisis Frieden: Global Imbalances, National Rebalancing, and the Political Economy of Recovery Backgrounder: Confronting the China-U.S. Economic Imbalance