Benn Steil


A graphical take on geoeconomic issues, with links to the news and expert commentary.

Posts by Category

Showing posts for "Capital Flows"

Luck of the Irish Hinges on Banks


The EU-IMF Irish bailout gives Ireland a window of opportunity to solve its problems, but how large a window is it? Although the €85 billion headline number appears to be very large, at over 50% of Irish GDP, the funds must be benchmarked against what they are being earmarked for. €50 billion is tagged for public finances, which will cover two years of public debt refinancing and deficits. This provides a significant window for Ireland to achieve fiscal improvement. However, the window provided by the €35 billion tagged for banking sector recapitalization is much smaller. Over €34 billion of foreign deposits fled Irish banks in September 2010 alone. Over the past two years, Irish banks’ balance sheets have shrunk by over 9%, while their funding reliance on the European Central Bank has increased from 5% to 9% of total liabilities. This suggests that any Irish bailout plan, to be credible enough for the markets, must ensure that the Irish government ceases adding bank debt to its public debt. That will almost surely involve a restructuring – that is, a significant partial default – on the bank debt. Such a restructuring, however, will raise a slew of new bailout questions, since German, French, British and other European banks holding Irish bank debt may themselves require public assistance to remain acceptably capitalized. Read more »

P.I.G. Government vs. Corporate Debt


The risk of corporate debt is often measured by looking at the spread between its yield and similar ‘risk-free’ government debt. The higher the spread, the greater the risk. However, when government credit comes into question, this spread is no longer suitable as a measure of corporate risk. The spread does, nevertheless, tell a story about relative risk. In Greece, Ireland, and Portugal, a number of sectors have negative corporate spreads, suggesting that firms are either less likely to default than their governments or will have higher recovery rates if they do default. The sector that stands apart as being much riskier than the government is financials. If these governments partially default, the guarantees they have made to the banking system are no longer credible, and the credit losses may be severe. Read more »

Greek Debt Crisis – Apocalypse Later


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. Read more »

Beware the “Reverse Conundrum”


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. Read more »

The Dangers of Debt: Russia and China’s GSE Dumping


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. Read more »

Beware of Greeks Bearing Debt


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.’ Read more »

European Default Risk Replaces Inflation Risk


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. Read more »

Greek Drachma: Not an Option


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. Read more »

America as the World’s Risk Taker


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.

What Happens When the Fed Stops Buying Government Debt?



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. Read more »