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Emerging Markets

Pain now, gain — maybe one day

Apart from a few virtuous souls, most governments around the world run budget deficits, much of the time. It’s all fine until the bond vigilantes come knocking on your door. When that happens, the markets expect you to put your house in order yesterday. As Jon Hay reports, fiscal adjustment is not the end — many countries have survived it and come out healthier. But while it’s going on, the cure is likely to feel worse than the disease.

  • 13 Dec 2011
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In 2011, according to the IMF, Ireland will have a budget deficit of 10.3% of GDP. So will Japan.

But while Ireland has no chance of borrowing any new long term money this year, except from the EU partners that bailed it out a year ago, Japan can issue 10 year bonds to private investors at 1% or less.

Right behind these two at the top of the advanced economies’ deficits league table are the US, on 9.6%, the UK on 8.5%, and Greece with 8%.

Not even the wildest scaremongers are talking about Japan, the US or UK needing to be rescued. Yet Greece has had two bail-outs and is now on the verge of a debt restructuring.

These starkly different outcomes tell us much about the nature of sovereign debt. "The issues are not the same in every country," says Lorenzo Pagani, head of European sovereign bonds at Pimco in Munich. "Even among those which have been severely impacted by the crisis, some have no problem of deficit, such as Italy."

Italy’s budget deficit this year is projected at 4% of GDP — less than Canada’s 4.3%. Yet that is small comfort to Italians, whose government is in danger of losing investors’ confidence altogether.

Market participants might be tempted to conclude that deficits are irrelevant to sovereign creditworthiness. But that is clearly not the case. "At the end of the day, it’s the same for a country as for a person — you can’t spend more than you earn," says Ville Talasmäki, vice-president of credit investments at Sampo Group in Helsinki. "If you do it for too long, you’re toasted. The difference is that on the government side, there have been a lot of people willing to fund it."

That willingness can disappear almost overnight, as Greece, Ireland and Portugal have already found, and Italy, Spain and France are now learning (see box on next page).



Easy money no easy answer

What should countries in this predicament do? And how can states avoid getting to the point of danger in the first place?

The bad news is, governments wanting to improve their debt sustainability have few options — all of them unpleasant. "Countries that can control their currencies have a different set of alternatives to pay down debt from those that can’t," says Pagani. "In the US and UK the central bank has been monetising debt. In the Eurozone the European Central Bank is buying bonds, but in very small quantities."

For states that print their own currencies and set their own interest rates, generating inflation is one way to reduce the burden of debt on an economy — though it is a gamble. "One mistake some people are making is to call for higher inflation as a way out of the mess," says Paul van den Noord, economic counsellor to the chief economist of the OECD in Paris. "If you could manage to increase the inflation rate, which is not easy in a slump, almost immediately bond yields would go up by almost that amount — not just because of higher actual inflation, but because of greater uncertainty about inflation."

A country that wanted to attempt this would have to be trusted by bond investors — yet generating inflation would be likely to undermine their loyalty.

Pagani points out that inflation, just like default, destroys value for savers. "The inflation method allows you to distribute losses over a longer time," he says. "A restructuring forces you to recognise losses very quickly. That might be a good thing or a bad thing — it can create contagion to other countries."

For the stressed countries in the Eurozone, inflation is not an option, in any case. Germany’s dislike of inflation is legendary, and even if the ECB wanted to stimulate some, it might struggle to do so.



Scant room for manoeuvre

The one element in the debt equation that governments can hope to control directly is the deficit.

As a result, cutting the deficit is top of the political agenda in many countries, from the US to the UK, France, Italy, Spain and the three bailed-out Eurozone states. But as all these countries are finding, it is an extremely difficult thing to do — and it may not even help.

"Austerity probably creates a lot of problems — it’s very counter-productive for growth," says Talasmäki. "But on the other hand, if no one will fund your deficit, what can you do?"

The stressed governments in the Eurozone are stuck deep in a crevasse. On one side is a rock: the market’s distrust of their lax fiscal policies. On the other is a hard place: if they tighten their budgets, it will probably cause an economic slowdown, which makes budget deficits even worse, and would make their debt look even bigger, relative to GDP.

Like Talasmäki, Gunther Westen, head of asset allocation at WestLB Mellon Asset Management in Düsseldorf, can see only one way out of this bind. "These countries have to calm market fears," he says. "Cutting the deficit creates a danger that you dive into recession, but they have to go that way."

The risks of this path are appreciated by many investors and analysts.

Jonathan Loynes, chief European economist at Capital Economics in London, says Ireland could be seen as a cautionary tale of what can happen if you tighten too aggressively. "Early on in the crisis, Ireland looked good," he says. "They made an early fiscal tightening. Then it all went wrong — the economy slumped and they needed a bail-out."

At the same time, Ireland’s economic model was an accident waiting to happen. Antonio Garcia Pascual, chief southern Europe economist at Barclays Capital in London, argues that its large imbalances left the country exposed to a fall in house prices. "Right before the crisis," he says, "Ireland had a very lax fiscal policy. It looked like they had a budget surplus every year, and real GDP growth was running at 6% or 7%. But if you adjust for the cycle and the house price bubble, Ireland was running a deficit, when they should have been running a surplus. They had very low taxes, with lots of exemptions."



Going for it

The medicine of a budget clampdown, then, may have been inevitable for Ireland. No one doubts the ardour with which two successive governments have pursued austerity.

A year after the bail-out, "the progress is clearly on track," says Garcia Pascual. "Some tax revenues have been a bit weaker than expected, but they have compensated with further cuts in capex."

Markets have noticed. Ireland’s 2020 bond yield has come down from 13.8% in July to around 8%, though it spiked again to 9.5% in late November.

However, the price has been savage. Unemployment has almost tripled since 2007 to 14%, wages have fallen in both private and public sectors and in 2010 the budget deficit was still 32% of GDP. This year it should only be 10.3%, declining more slowly thereafter.

Debt specialists are not sure yet that Ireland will pull through and recover without defaulting — but the country has a chance.

What is clear is that even with Ireland’s tough approach — and its economic advantages, such as a legal climate favourable to business — coming out of a debt crisis takes time. If it succeeds, Ireland will only have been able to do it with EU help.

Austerity measures and reforms, argues Westen at WestLB Mellon, "will only bear fruit in three or four years, and the markets are not giving the peripheral states any time".

Hence the urgent need for what Pagani calls a "bridge between the current crisis and the moment when reforms will give their results".

Whether that bridge may come as support from other EU governments, or from the ECB, is the subject of other articles in this report. Analysts agree, however, that the unpredictable violence with which the bond market can desert a previously favoured borrower is incompatible with the timescale of the reforms which that desertion appears to demand.

"At a time of extreme panic and uncertainty, markets want red meat," says Nicholas Spiro, head of Spiro Sovereign Strategy in London. "The only red meat that governments can throw at them in the short term is fiscal austerity — even if it’s a disaster for growth."



Two views of Greece

Greece is trying to tread the Irish path into the underworld and out the other side. So far, it is all darkness. "Greece’s budgetary measures have been extremely successful in the amount of fiscal consolidation they’ve generated," says Jacques Cailloux, chief European economist at Royal Bank of Scotland in London. "It might be one of the few countries that’s achieved such an improvement. But the starting point was so bad that they have not reached their targets."

The Greek budget deficit came down from 15.5% of GDP in 2009 to 10.4% in 2010 and an expected 8% this year, according to the IMF. All that has been achieved with spending cuts, since government revenue has stayed flat, at about €88bn. Expenditure will be 15% lower in 2011 than in 2009. Meanwhile, unemployment has doubled since 2008, to 16% this year.

Despite all this sacrifice, Greece is still perceived by some to be failing. "In theory, the adjustment programme was well constructed, possibly with some overly ambitious targets, but implementation has been extremely disappointing," says Garcia Pascual. "The government may have chosen to delay tougher measures because they are too politically costly. For example, they have not reduced the public sector wage bill even close to what is enough."

In Cailloux’s view, the targets agreed with Greece were probably never achievable. "The assumptions on growth were too optimistic," he says. "The contraction this year will be 6%, not 3%. And the fiscal targets are unconditional, whatever the state of the economy. It’s become a quarterly nightmare, where they get punished for missing the targets."

Even with private sector debt reduction and optimistic growth forecasts, Greece’s debt is only predicted to fall back to 120% of GDP by 2020. "To do that, the country will have to run a 4.5% primary surplus from 2015 to 2020," says Cailloux, "something no comparable country has really had for such a long time."

Greece highlights the great differences between countries struggling with their debts. While the UK, Ireland and Spain’s problems were all caused by banks lending recklessly against property, Greece suffers from a sluggish and uncompetitive economy and a bloated, inefficient public sector.

"This crisis has exposed long term structural and institutional problems in the Greek economy," says John McNeil, investment manager at Kames Capital in Edinburgh. "The normal institutions of a developed country just don’t function properly."

Control of the public administration and public enterprises has been poor, Garcia Pascual argues, and tax avoidance is rampant. One estimate is that Greece loses €60bn a year to tax avoidance — about a fifth of its entire debt.

This may be one reason why Greece’s social turmoil has been so much worse than Ireland’s. "Ireland has perhaps been relatively well able to deal with fiscal contraction because people realised that the country in general had got a lot wealthier during the boom, and they were willing to give some of that back to get the country out of trouble," McNeil believes. "In Greece, the increase in wealth may have been misallocated across society, so the people in the middle think some elite has creamed it off."



Does one size fit all?

Since economies and cultures differ so much from each other, why is the same recipe of austerity being applied across the board?

"Italy has a primary surplus," says Spiro. "France has a primary deficit of over 3% of GDP. But Italy is being asked to embark on one of the most savage fiscal adjustments, over two years. This is a huge mistake — it will definitely contribute to a recession, tax revenues will drop and you could have a Greek-style situation."

What Italy needs, many agree, is measures to address its lamentable record of low growth. "There has been a notable shift in bond markets in the past half year," Spiro believes, "especially with regard to the peripheral economies, and very much influenced by Greece. The general view is that austerity is becoming self-defeating and there is little point in persevering with it aggressively. Bond market credibility has as much or more to do with growth as fiscal discipline."

Structural reforms to promote growth are expected to be at the heart of Italian prime minister Mario Monti’s programme. Barclays’ Garcia Pascual has some advice for him: "On the pro-growth structural policies, it should include labour market reform, to reduce hiring and firing costs, moving collective bargaining to the firm level, and raising the retirement age for women to align it with men’s."

Spain’s Mariano Rajoy, elected prime minister on November 20, faces a similar challenge.

All this Monti and Rajoy may try to do, but deep budget cuts are also still part of the EU’s recipe for recovery. As Garcia Pascual adds in Italy’s case: "The government should also deliver seamlessly the proposed fiscal consolidation programme."

One reason is the "red meat" argument — there is no other way of showing investors an immediate commitment to fiscal discipline.



Hope from the past

Another is that it has worked in the past. The examples routinely cited are Canada, Sweden and Denmark, all of which achieved, in the mid-1990s, the ideal of an ‘expansionary fiscal contraction’ — they cut budget deficits and their economies rebounded quickly.

Cailloux believes the EU policy response to the debt crisis has been based on this ideal. "By rebuilding confidence in the public finances, you try to bring back investors," he explains. "But the nature of the crisis is that the market will take more time to come back. And the monetary union means there is an exit risk, which makes it harder to attract investors."

In crucial respects, the task facing Eurozone countries today is much harder than what Canada and Scandinavia dealt with. "Sweden and Denmark did it through devaluation," says Ville Talasmäki at Sampo. That option is closed to euro members.

And in the 1990s, the recovering economies were helped by a benign worldwide economic climate, instead of facing a probable recession in their home region.

Nevertheless, the Scandi-Canadian experience has bequeathed one widely accepted rule of thumb. Successful budget contractions, economists say, derive between 20% and one third of their savings from tax rises, and the rest from spending cuts.

According to IMF figures, for example, the UK is expected to raise government revenue by one percentage point of GDP between 2010 and 2016. Spending, meanwhile, will come down by 6.8 percentage points.

Whether this is genuinely the best model, or the right one for all economies, is little understood. In France, for example, taxes and spending are both high, suggesting there is more room for spending cuts than further tax rises. On the other hand, French citizens are clearly more tolerant of taxation than those in the US, where many reject any rise in taxes, even from their present low base. In that society, there are strong justice objections to making most of the burden fall on spending cuts.

In Italy, tax rates are high, but widespread avoidance means stricter enforcement might do more good than new levies.



Lots of options

Faced with so many imperatives and risks, what should the wise finance minister do?

An antidote to the prevailing gloom comes from Paul van den Noord at the OECD, who believes many governments have scope to lop large chunks from the budget deficit, or eliminate it altogether.

"Countries are doing the right things, but not enough," he argues. "We think some OECD countries could cut up to 1.3% of GDP from their education budgets and 2% of GDP in health," he adds, through efficiencies, "without compromising the quality of public services".

Subsidies for industry and housing could be reduced and disability, unemployment and retirement benefits reformed. "Some of these measures can reduce public expenditure and at the same time increase potential output and employment," van den Noord says, making the fiscal consolidation easier.

On the revenue side, the OECD sees three main areas for action. The first is so-called ‘tax expenditures’, or tax breaks. "These can be very sizeable – about 20% of GDP in the US," van den Noord says. "One of the big ones there is mortgage interest being tax-deductible. If you removed that, there would be a huge revenue gain and the tax system would also become less distortive, which could potentially lead to higher output."

In the UK, mortgage interest tax relief was abolished in 2000, but sales of primary homes are exempt from capital gains tax, a huge tax break for the middle class in property-obsessed Britain.

A second area for revenue improvements is tax reforms that are revenue-neutral but would lead to higher growth, indirectly improving the budget balance. "Lower personal and corporate income taxes would help, because they are distortive and reduce incentives for employment," van den Noord believes. "Higher taxes on consumption and property would be better."

Consumption taxes like VAT are usually seen as regressive, though van den Noord believes that can be mitigated by applying different rates. They are also rarely seen as growth-enhancing. Property taxes, on the other hand, might discourage people from tying up money in real estate and encourage investment in productive financial assets instead.

"The third area where we see huge scope for increased revenue is taxing ‘bads’ such as pollution," says van den Noord. "For example, you could raise 2.5% of GDP by taxing greenhouse gas emissions. And there’s a double whammy if you remove green subsidies and replace them with taxes that provide the same incentive."



Look to the union

While the OECD’s ideas may be among the least economically damaging ways for countries to rein in their public finances, there is no hiding the personal suffering and dislocation their implementation would cause.

Moves to cut deficits aggressively are likely to spread in Europe. "Increasingly we will see more conditionality imposed on the larger countries in Europe, both from the markets and from the EU," says Cailloux.

So far, only Ireland and the Baltic states have shown signs of coming through a severe retrenchment with improved prospects. With Italy and Spain, investors may be waiting for firm evidence of progress on implementing reforms before giving them a break.

It is not clear, however, that even the best package of improvements, flawlessly implemented, would now be able to restore market confidence. "If Rajoy committed himself this week to balancing the budget as quickly as possible, I very much doubt you would see a drop in Spanish yields," says Spiro. "We have passed the stage where domestic reforms alone can have any influence on the outcome."

For Pagani, policy moves might be reassuring "if the rules of the game were known". Instead, there is radical uncertainty. "The current situation is a union that’s unsustainable in the present framework," he says.

EU leaders are now negotiating hard to find a path towards a closer, more fiscally disciplined union. Until a convincing deal is reached, the only path for many European countries is the cold way of austerity and economic reform, with little prospect of earning much credit for it in the markets.

   
 

The deficit alarm bell: why now?

  Markets can remain willing and trusting for a long time — even decades — while countries follow spendthrift fiscal policies. Neither Italy, nor France, the US, Greece, Japan, Austria — even Israel and Taiwan — has had a balanced budget this century.

Yet all have been able to borrow at favourable interest rates for most of that time. Only in 2010 did Greece lose market access, while Italy’s has become stressed since July 2011.

Sentiment can turn extremely quickly. It took three months in 2010 for Ireland’s 10 year bond yield to leap from 5% to 8%. This year, Italy has gone from 5% to over 7% in four months. Neither of these shocks was caused by new events — rather, the market collectively lost confidence in a nation whose conditions had long been known.

Why are some states singled out by investors for rejection, while others continue to be indulged?

Economists predict countries’ debt dynamics, using the key factors of the deficit, the overall level of debt relative to GDP, the country’s actual and potential GDP growth, and its cost of funding.

Recessions, like the global one of 2008-9, change GDP very quickly, and tend to make deficits swell, as the ‘automatic stabilisers’ kick in: tax revenues fall as the economy slows, while unemployment benefit payments rise.



Falling into a hole

When both the deficit and GDP growth are bad, the national debt can expand very quickly. Germany was in a good position in 2008. It had just had two years of solid growth and balanced budgets, bringing its debt down from 68.5% of GDP to 65%. By 2010, the ratio had ballooned to 84%.

When this happens, you had better have a low cost of funding, and preferably, a well spread out maturity schedule, so that not much debt needs refinancing too soon.

Italy had the former, but in 2012 it will have to refinance €300bn of debt. At the low rates it has been accustomed to, that would not be a problem. Italy has been used for decades to spending a large share of its GDP on servicing debt. But that makes it very vulnerable to a sudden rise in interest rates.

All this has been evident for years, so why did Italy come under stress only in July? The answer lies in the self-reflexive nature of the interest rate element in the equation. A burst of market anxiety pushed the country’s expected cost of funding up, making the projections of debt sustainability look that much worse. Result: yields rose further.

Two lessons can be drawn. First, the factors that make a country’s public finances vulnerable are clear and understood by all. The information is easily available. But a country only needs to score badly on some of the indicators to face a potential debt crisis.

Second, markets are highly unpredictable — even irrational. Investors may become intolerant, without much having changed fundamentally.

As Lorenzo Pagani, head of sovereign bonds at Pimco in Munich, says: "Once credibility is lost, to regain it takes a lot of time and a lot of hard results."    
   
 

US and UK among favoured few: those with time 

  All indebted countries face the same dilemma: cut the deficit to restore market confidence or keep borrowing to stimulate the economy. Some, though, have a little more room for maneouvre than others.

"The UK and US are true sovereigns," says John McNeil, investment manager at Kames Capital in Edinburgh. "There is a very high value in that — they control their own monetary policy. The Eurozone countries have given so much of their sovereignty away — they can’t do QE or devalue."

It is debatable how much the US and UK have been able to use monetary policy to reduce their debt problems. But one thing is sure: domestic pension funds and insurance companies are virtually forced to hold their debt, to avoid currency risk and comply with solvency rules. That gives these countries some policy leeway that Eurozone countries lack.

"A country in a difficult fiscal situation but still credible with the markets can create fiscal space for stimulus," says Paul van den Noord, economic counsellor at the OECD in Paris, "or at least to let the automatic stabilisers work, on condition that it adopts a very credible medium term fiscal plan. This is what Britain has tried to do — and what in the US seems not to work as planned."

November brought the failure of Washington’s Congressional ‘supercommittee’, set up to find a cross-party plan to cut $1.2tr from the budget deficit over 10 years.

Pension, healthcare and defence spending are all high in the US, but taxes are remarkably low — government revenue is only just over 30% of GDP, while spending is now above 40%. Democrats do not want to cut pension and health spending if taxes are not raised, something Republicans will not countenance.

This political paralysis has not so far not affected the US’s ability to borrow, but nearly all observers believe a reckoning will have to be made sooner or later. The IMF expects the US’s debt to keep rising for the next five years, reaching the Italian level of 115% of GDP in 2016.

America could be seen as taking a gamble: that the economy will return to growth soon, allowing it to address the deficit when times are easier.



Fast track to zero

The UK is doing what President Obama might like to do, if he could control Congress — aiming to reduce the budget deficit in planned stages, over several years. In fact, the UK is going further, striving to return to budget balance.

In 2010, when the UK’s Conservative-Liberal Democrat coalition came to power, the two countries had the same frightening budget deficit of 10.3%. But while America’s unique status as issuer of the world’s reserve currency gives it plenty of latitude, the UK is not so special.

Debt hit 68% of GDP in 2010, up from 52% in 2009. Britain’s new chancellor George Osborne felt the deficit had to be wiped out in the space of one parliament — five years.

In fact, his plans were only fractionally different from those of the previous Labour chancellor, Alistair Darling. But as Nicholas Spiro of Spiro Sovereign Strategy puts it: "From a market standpoint, Osborne has a spring in his step, he’s won the battle."

The markets have given the UK some credit for having set a clear course towards fiscal rectitude. As McNeil at Kames Capital points out: "The UK’s government bond yields are very low at the moment, but we have no idea what the counterfactual is." Had the UK been seen as dilatory about budget tightening, Gilts might have faced a sell-off like some Eurozone government bonds.

That danger, at least, is not an immediate threat to the UK. But one analyst warns: "Anyone who thinks Gilt yields are at an all time low just because of the credibility of Osborne’s plan is deluding themselves. The UK economy is on its knees, it’s nearly certain that the Bank of England won’t raise rates for years, and there’s likely to be even more quantitative easing."



Hill gets higher

One cannot know for sure how much of the UK’s economic slowdown in 2011 has been due to government austerity and how much to the gloom in Europe. Slow down it has, though.

Jonathan Loynes, chief European economist at Capital Economics in London, believes Osborne was right to make sure there would be no run on UK debt, with "a fairly strong statement of intent". But, he adds: "He needs to strike a balance. He can’t be seen to be abandoning consolidation, because markets could change their minds. But I’m open to the idea of the fiscal squeeze being throttled back."

The UK’s Office for Budget Responsibility reported at the end of November that the deficit cutting plan was off track, with budget balance most likely to be achieved two years later than planned, in 2016-17, as the economic downturn has made it harder to balance the books.

Loynes says there was always "elbow room" in Osborne’s plan to take a softer route — for example, the target is defined in terms of cyclically adjusted current borrowing, which takes account of the economic cycle and excludes capital spending. The chancellor exploited this in his autumn statement with measures to guarantee small business loans and stimulate infrastructure investment.

For Loynes, however, "it’s too little, too late. It will be impossible for the UK to avoid slipping into a recession." As the economic pain worsens, it will become harder than ever for the UK to stick to its path of budget tightening.    
   
 

Italy: how no deficit problem became a huge one

 
 Despite its long record as Europe’s most indebted country (surpassed only in 2006 by Greece), Italy has been fairly well disciplined about its budget in the past 15 years, at least by the standards of debt-loving rich countries.

Between 2000 and 2008, the government deficit averaged 2.9% of GDP, within the Maastricht treaty target of 3%.

During those years, Italy managed to bring its debt down, from 109% of GDP to 106%, because nominal GDP growth exceeded the deficit.

When the crisis struck, Italy also fared better than some of its neighbours. Government borrowing swelled from 1.5% of output in 2007 to 2.7% in 2008, 5.3% in 2009 and 4.5% in 2010. This year, it is expected to be lower, at 4%.

Lorenzo Pagani, head of European sovereign bonds at Pimco in Munich, argues that it was countries with private sector asset bubbles where the sovereign balance sheet was most contaminated by the crisis. "Italy didn’t really have a bubble," he says.

"The banking system was focused domestically, without the excesses of Ireland, Spain or the US."

The UK, Spain and Ireland have all swung into huge deficits since 2008 as governments have had to step in and rescue the economy after a debt bust — either by bailing out the banks, or through automatic stabilisers, such as losing revenue from housing and sales taxes, while unemployment benefits rose.

"Italy had a scheme in 2009 to let the banks issue government-guaranteed bonds, like the other countries did," says Pagani. "They didn’t issue a single bond — they didn’t need to."



Monstrous load

Italy has two big problems, however: a whopping backlog of debt and dismally low growth in real terms. The country has lived this way for decades, even with higher interest rates than today’s — one reason why some Italians have found it hard to see what all the fuss is about.

But in 2011’s climate of self-fulfilling panic, Italy is in grave peril of being comprehensively deserted by investors. Regaining their confidence, which Italy must do as soon as possible, will require painful belt-tightening by the government.

Already in April, prime minister Silvio Berlusconi’s administration was planning to rein in the budget deficit, to 3.9% of GDP this year, 2.7% for each of the next two years, and 2.6% in 2014.

The primary budget balance — the state’s surplus before paying interest on its debt — was supposed to hit a 0.9% surplus this year, rising to 2.4% in 2012 and higher thereafter. Assuming benign funding costs, that would have enabled the debt to peak at 120% of GDP this year.

This plan involved raising €26bn of extra revenue in 2011-13, €20bn of which was to come from clamping down on tax and social security evasion, with a one-off bonus of €2.4bn from selling radio spectrum.

Meanwhile, the government aimed to cut €47bn of spending, including €2.3bn from ministries’ operating costs, €7.7bn from the public sector wage bill and €9.5bn from pensions, healthcare and social costs. Another €16bn would be lopped off capital expenditure and €11bn from subsidies to the regions and municipalities.

That was before the crisis engulfed Italy when bond yields soared in July. By August, finance minister Giulio Tremonti was sweating from every pore. A succession of ever more severe fiscal packages was negotiated with the EU and passed by parliament during the summer with unusual speed.



Tighter and tighter

By September, the plan was to reduce the deficit by €59bn a year, or 3.4% of GDP, so that the budget would be close to balanced by 2013. Most of the measures were frontloaded to 2012.

Besides further public spending cuts, the government decided to raise the VAT rate, make women in the private sector retire later, reduce tax breaks, limit municipalities’ ownership of utilities and eliminate one entire layer of government — the provinces.

Not only that — Italy proposed introducing a balanced-budget rule to its constitution.

None of this has been enough. In the dying days of Berlusconi’s premiership, further measures demanded by the EU were added to the 2012 budget, including a promise to sell €15bn of state assets in the next three years and raise the retirement age to 67. The finance ministry is reported to have picked out €400bn of real estate that could be sold off.

In early December, Italy’s new prime minister Mario Monti announced yet another package of reforms, including property and wealth taxes and further cuts to pension entitlements. Though clearly worried by the risks austerity poses to the economy, Monti has reaffirmed his commitment to balancing Italy’s budget in 2013.
 
   
   
 

Privatisation: no panacea

 
 One option for cash-strapped governments is privatising state assets. But as with all budget-trimming measures, this has some downside and is hardest to do when you need it most.

"Privatisation is a possibility," says Gunther Westen, head of asset allocation at WestLB Mellon Asset Management "But it takes time — you don’t want to sell at any price."

Selling assets requires finding buyers, and when an economy is in distress, they tend not to come flocking, unless they can pick up exceptional bargains. "Privatisation is off the agenda," says Nicholas Spiro of Spiro Sovereign Strategy in London. "It’s hard enough for the blue chips to raise capital in the equity markets, quite aside from all the political and union resistance."

However, Greece’s Eurozone bailout package relies heavily on the state promising to sell €50bn of assets in the medium term. "Europe has this view that Greece’s problem is a lack of willingness to pay, not a lack of ability," says Jacques Cailloux, chief European economist at RBS. "They say ‘you have all this wealth in your country, so you can pay the debt back’. The problem is, it’s a very distressed environment. You can’t just sell them."

Greece had a target of raising €5bn through privatisation this year. It has managed to find €400m. "These plans are much more aggressive than the pace of privatisation that Italy achieved in the 1990s, which was about the fastest ever," says Cailloux. "It’s not going to be possible."

Portugal and Italy are facing similar choices (see box on page 51). "They have liquid assets," Cailloux explains, "stocks in quoted companies. These are priced in real time so the sovereign can decide to sell, but does it make sense? These markets have already been hit quite hard and the money they’ll get is not enough to make any difference to the debt. Then there are unquoted companies and real estate, which might find a price. But they are often owned by local governments."

Some argue it is time for Italy to sell a portion of its state land. Yet a flood of it on to the market would depress prices and could lead to other problems, such as the kind of speculation that infected Ireland and Spain.



The unmentionable: structured finance

Of all the ways for governments to reduce their deficits, perhaps the least in vogue is structured finance. Such deals would be impossible now in distressed economies, where even government bonds are not trusted, but nations with healthier finances could still consider them.

However, the association of structured finance with toxic financial excess is so strong now that governments may prefer to avoid it.

Securitisation was widely used in the early years of this century by governments including the UK, Italy and Greece. Two packages of UK student loans were sold to a combination of junior and mezzanine investors and ABS investors, raising money that the government could use to redeem Gilts.

Greece raised €650m in 2000 by securitising lottery ticket sales, and another €355m the following year by parcelling up air traffic control receivables.

Italy was the heaviest user, with a string of deals including the INPS transactions, secured on social security contributions, INAIL, based on employers’ liability insurance payments, SCIP, backed by property, and SCIC, using educational research loans.

"It’s much more difficult now because Brussels frowns on it, even though the EFSF is a perfect example," says Spiro. "Countries used it to massage their figures to try and comply with the Maastricht treaty. But you can bet it will be one of the options that’s considered."
 
   
  • 13 Dec 2011

Bookrunners of International Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 28 Jul 2014
1 HSBC 37,016.70 233 10.52%
2 Citi 35,974.22 170 10.23%
3 JPMorgan 31,371.77 130 8.92%
4 Deutsche Bank 28,261.94 134 8.03%
5 Bank of America Merrill Lynch 18,085.62 98 5.14%

Bookrunners of LatAm Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 29 Jul 2014
1 HSBC 10,470.96 36 11.22%
2 Deutsche Bank 8,464.10 30 9.07%
3 Citi 8,423.34 38 9.03%
4 JPMorgan 8,213.23 29 8.80%
5 Credit Suisse 7,139.95 23 7.65%

Bookrunners of CEEMEA International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 29 Jul 2014
1 Citi 12,485.54 45 13.13%
2 JPMorgan 11,127.22 30 11.70%
3 Barclays 7,913.99 22 8.32%
4 Deutsche Bank 7,763.51 29 8.16%
5 HSBC 7,588.04 31 7.98%

EMEA M&A Revenue

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 28 Jul 2014
1 Goldman Sachs 257.30 81 8.77%
2 JPMorgan 246.40 81 8.40%
3 Lazard 177.66 99 6.05%
4 Bank of America Merrill Lynch 176.46 62 6.01%
5 Deutsche Bank 175.08 66 5.97%

Bookrunners of Central and Eastern Europe: Loans

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 29 Jul 2014
1 Deutsche Bank 1,077.99 6 8.35%
2 ING 1,017.60 11 7.88%
3 RBS 940.38 3 7.28%
4 SG Corporate & Investment Banking 847.35 8 6.56%
5 UniCredit 770.52 7 5.96%

Bookrunners of India DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 30 Jul 2014
1 Standard Chartered Bank 3,027.03 22 11.96%
2 AXIS Bank 2,167.77 54 8.56%
3 Deutsche Bank 1,989.26 25 7.86%
4 HSBC 1,537.78 14 6.07%
5 Citi 1,514.67 10 5.98%
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