Sovereign Debt : Not as virtuous as you once were ? No matter ..... not yet anyway.

Sovereign Debt : Not as virtuous as you once were ? No matter ..... not yet anyway.

ref :- "Undaunted by downgrades" , Buttonwood in the Economist, Finance and economics

If you understand a nation's credit rating to be an assessment of the risks, including political risks, attendant on investing in that nation, then you can also understand why achieving the top AAA rating has been so highly valued over the years. Not only would such a status encourage the direct foreign investment that is crucial to the economies of many of those countries in the top tier, but it has also enabled them to borrow at noticeably lower rates than their more lowly-ranked competitors.

Buttonwood reminds us that soon-to-be UK Chancellor of the Exchequer George Osborne made something of a rod for his own back before the Tory party's electoral success in 2010.  He declared that one of the prime objectives in cutting the budget deficit was specifically to maintain the UK's AAA rating.  On assuming the hot seat, Mr Osborne embarked on a programme of spending cuts and tax increases to improve the public finances. Each will have his or her own view on whether that kind of austerity package was sensible or desirable, but whatever the case poor George was not able to deliver on that particular goal. The UK was downgraded in 2013.

Mind you, the UK is not alone in having endured a rating relegation. Depending on which agency you're following, there are now only 11 countries with the ultimate AAA accreditation, down from 16 in 2009. By value, 40% of global sovereign debt has the top rating, down 8% from ten years ago.

***  NOTE 1 : There are a number of credit ratings agencies to offer their opinion on such things, although generally the most closely watched are Standard and Poor's, Moody's and Fitch (the "Big Three") and to a lesser extent DBRS. This Canadian outfit was in the spotlight recently however for throwing a lifeline to Portugal by (just) maintaining its investment grade rating for that nation, the only agency to do so. Such approval, tenuous though it was, meant that Portugal could still qualify for the ECB's bond-purchasing programme (QE). ***

Unsurprisingly, the downgrading of a sizable slice of previously top-rated sovereign debt was an after-effect of the global financial crisis. Low growth and reduced tax revenues are not a recipe for robust economic health. But countries slipping down the divisions have not had to pay any penalty for their larger debt ratios as ultra-low bond yields globally and central banks bond-buying have kept a ceiling on what they have to pay for their borrowing.

There are myriad examples of this. Take Japan : it lost AAA rating in 2001 as economic contraction meant that its debt-to-GDP ratio went through the roof, but that had virtually no effect on the appetite of investors to buy its bonds. A deflationary spiral may be what the authorities most dread, but for investors the low bond yields on offer look more attractive if prices are falling. If inflation is negative, obviously REAL returns (yield minus inflation) actually improve.  And just in case, they have always been able to rely on Bank of Japan buying to put a floor under their own purchases. What about the USA, the world's largest government bond market and the benchmark for all others ? S & P withdrew its AAA rating from the US in 2011, but if anyone was expecting yields on US Treasuries to soar in consequence they'll have been pretty shocked to learn that 10yr yields hit a record low of 1.36% five years later.

The big players in bond markets used to punish governments for fiscal irresponsibility by aggressively selling their debt, and earned the soubriquet "the Bond Vigilantes". Without question they were a threat to any politician contemplating any over-loosening of the fiscal reins but clearly today they do not exert anything like the same influence. Such is the requirement for commercial banks, pension funds and insurance companies to own government debt for liquidity or regulatory reasons, the impression is that sovereign bonds will still be bought whatever the yield and irrespective of downgrades.

These days the argument goes that the difference between a AAA-rated bond and a AA-rated bond, in terms of probability of default, is so slight as to be virtually non-existent in practical terms.

So we've now got a situation whereby governments are not punished by the markets for running big deficits and can issue debt at ultra-low rates of interest. In those circumstances, how many politicians are likely to run the risk of upsetting voters by imposing austerity measures and limiting borrowing ? Even ever-prudent Germany has a debt-to-GDP ratio of over 70% ;  the target level set for eurozone nations at Maastrict at the Euro's inception was 60%. It kind of goes without saying that there's no sign of any rap on the knuckles for Germany from the ECB or its single currency peers, but there has been no adverse market reaction either. Even after the recent global spike in bond yields, Germany's 10yr debt is trading at just 0.32%

It's likely that politics will provide the background for the big test as to how much government debt can be absorbed , and for how long. The populist agenda led by Donald Trump is one of tax-cutting and increases in infrastructure and military spending. Assuming the administration's new measures get through Congress, it is estimated that US sovereign debt will rise to 105% of GDP (from 77%). On the other hand, the last thing that mainstream governments are likely to do is to cut spending and raise taxes in the pursuit of a balanced budget. They've got populism problems of their own and they wont want to implement any voter-unfriendly plans that would play into the hands of the likes of Marine Le Pen in France or Geert Wilders in Holland.

As things stand right now, the debt burden faced by most nations at current low levels of interest is eminently serviceable. Currently, the most popular argument is that the priority for governments right now should be to encourage growth rather than to obsess about austerity. But what happens if and when yields rise 2 or 3% ? As Buttonwood points out, government budgets are likely to already be under strain from rising pension obligations and healthcare costs from ageing populations. Bond markets will struggle to take that in their stride. CUE : The return of the Bond Vigilantes ?

*** NOTE 2 : 11 nations ranked AAA by S & P , excluding Hong Kong : Australia (just), Canada, Denmark, Germany, Lichtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland. ***