Tuesday, 27 January 2009

Britain, An Unlikely Default Story

When I moved to the UK a few years ago, I did not expect that I would ever take a break from my new discipline, global economics, and return to the old one, emerging markets macro. And especially not with my new home country being the subject matter. And yet, the day has come. The fiscal response to the credit crunch combined with the implied and not-so-implied spending promises by the government towards a host of different industries - among them practically the entire financial sector - translate into an essentially unlimited government guarantee of the British economy. This, as I pointed out earlier, is a gamble on time, a bet that the global crisis would not last very long and thus that the state’s guarantee about keeping the entire economy afloat would never be called in. Now, it seems, that bet is lost.

Let me tell you what a pair of macro eyes that were trained by watching emerging markets sees now in the UK.

First, a country needs to have really bad numbers to go into default. That is a necessary condition. There is no amount of bad policy that could force insolvency in itself, unless, of course, a madman was in charge. (For an example of the latter, see North Korea 1987). You need awful numbers. Otherwise, bar that madman case, any government can avoid bankruptcy by changing its policy course, probably in line with the demands of the creditors (usually coming in the form of IMF ‘advice’). Turkey 2001 for instance had really bad numbers: large twin deficits on current account and budget, coupled with a largely malfunctioning banking sector. (For a brilliant summary read Ozatay&Sak)

The UK is producing some spectacularly bad numbers. Yet, the current picture looks bleak only in the mature economy context. As far as emerging markets go, there would still be a long way before hyperventilation really started… (Try, for instance, comparing the current UK situation to that described by the above mentioned Turkey crisis paper.)

Second, the country needs to have ineffective government levers. The point in debt default is that you can’t find anyone else to give you any loans with which you would be able to cover your previously set payments. Nobody, at any price. Which means that your would-be creditors think that the level of your debt burden is larger than anything you could ever collect in taxes, at any probability. This does not really happen with well-managed economies. This is one of the main differences between countries that we call ‘mature’ as opposed to ones that we call ‘emerging’. In an emerging market you tend not to trust the government (usually alongside the entire population…) to have the means to get debt payments collected. In 1997 and the first half of 1998, for instance, Russia was hit by a string of external shocks, a combination of bad policies (e.g., exchange rate regime), budget blasts (the cost of a war), and a worsening international finance environment (1997 Asian crisis melting demand for bonds), and falling commodity prices. Even then, all of these would not have been enough to sink Australia for instance. Thus for a sovereign default, you needed to have an inefficient government, too.

The UK is clearly a very well-run economy, with extremely well-oiled levers. It would need to be far from the current situation for us to need to start worrying about it. (The spectre of net government debt rising from 36% to 60% might be unsettling, perhaps. However, if this was an emerging market you would not even blink, as long as you trust the government to be able to control the process. You would call it ‘timely correction’, and ‘rightful counter-cyclical fiscal measures’.)

This is especially the case given that UK government debt is in pounds. You need to have a particularly stupid government/unlucky country to run into default due to a run on domestic currency-denominated debt. (Argentina 2002 defaulted for instance as nobody was willing to refinance its external - mostly dollar-denominated - debt. Had the government debt been denominated in peso, they could have avoided insolvency. At least for a while, as they also managed to meet the other criterion...) You might think that some of the policies of the British government are debatable. But that is not enough. We are nowhere near.

Third, although the default does not necessarily come as a surprise, it tends to. Especially, if the financial sector is not well developed. Any emerging market government presiding over an economy with a mature financial system would, in practice, see many first signs, such as the premium on its previous debt obligations going sky high, before creditors, en masse, would turn away from it.

Have you seen the UK Treasury spread lately? You would need a different number of digits!

In conclusion: fears about the UK running into insolvency any time soon are far (far, far)- fetched. End of the Earth.


Having said that...

I would worry about the long-term implied guarantee though… At one point either the downturn ends naturally (if there is such a thing), or the global fiscal/monetary policy institutions are stepped up, or this country - and many others - will have to take back its word re what it would do to save its people. Still, defaulting on your promises is not the same as on your debt, is it?


  1. Do you still think so? The picture is much messier now.

  2. The author is nowhere near understanding the depth and breath of the problem in the UK. The discussion on the UK debt/GDP ratio underlines this point.

    UK's largest banking instutions have a combined balance sheet of 4 times GDP together ($5 trillion). Their assets are of poor quality, the consumer is maxed out on credit cards, the collateral quality on mortgages is deteriorating rapidly - collateral values were highly inflated by artificial low supply and excess demand, the availability of credit is non-existant. The positive inflow from banking on the current account and also from tax revenues has ceases. Imports are invoiced at the lower exchange rate pushing inflation higher and pressing consumers more. Immigrants who are solvent (or even more than the ones that are insolvent) consider leaving - that is unskilled and highly skilled labor. Immgrants may as well leave their bad debts behind them because the UK banking system has not the resources/organization to enforce a claim abroad. Solvent immigrants will not allow to being taxed excessive rates nor choose to hold their assets in the UK.

    And the madman in charge is Gordon Brown.

  3. The author, me, does not see how your argument goes against the blog post...

    The UK banking sector is in deep trouble. Sure. The contribution of the financial sector to the GDP is shrinking substantially. Some migrants might even leave. Some of them might even leave their bad debt behind. (Ironic that after immigrants were regularly accused of rigging the benefit system, not they are accused of a suspected, future disloyalty towards tax collector...) The weaker currency might indeed boost inflation a bit (although that should not be the main worry now, I think). It also makes the pound much more competitive than before. Witness the retail stats from the first months of the year: Europeans coming over to shop in London, for instance, and keeping up (returning) the momentum.

    The upshot of the UK banks' trouble is that the government will have to stop bailing out banks and people at one point (providing that the global crisis is to go on much longer). That's the main conclusion of the post, as well.

    I cannot see how the UK will default on its sovereign debt, though, unless the entire economy is wiped off. Which is not very likely, in my humble view.