Opinion The Dubai shake

Global public debt in 2010,according to recent analysis by Moody’s,will increase by 45 per cent — yes,45 per cent — from its 2007 level and reach nearly $50 trillion. Nearly 80 per cent of that jump will have been accounted for by the G-7 countries. Will the G-7,plus other European countries (Greece and Ireland,for example) that have piled up massive post-crisis public debt,spook the markets at some point of time? That’s the question thrown up by the Dubai debt problem — because psychology is not unimportant in market perception. This is more so when lenders hedge against default.

The last point is unappreciated in discussions on global public debt risk. There are credit default swaps (CDS,yes,the same CDS that almost became a household term post-Lehman) that insure lenders against public debt default. CDS contracts are useful for lenders; useful,too,as market markers of a sovereign borrowers’ capacity. But they can hugely increase the global impact of what is called a credit event: rumblings of debt repayment problems. If a CDS contract is written in a way that it becomes payable at the hint of a problem and if there are many,many such CDS contracts on sovereign debt around the world,a major financial impact can be produced without actual debt default. Incidentally,the cost of insuring G-7 sovereign debt has been going up.

In this mix one must add politics. Ultimately,lenders to governments judge the latter on their political determination. Politics decides whether there will be tax hikes and/or government spending cuts that make deficits sustainable. It determines the strength of debt repayment resolve. Dubai was supposed to have the political will to back its own creature,Dubai World. Now,Abu Dhabi is supposed to have the political will.

Of course,major rich countries or even minor European nations are totally different from sheikhdoms. For example,even though countries like Greece and Ireland are facing questions on their sovereign debt,markets have the assurance that their being part of the eurozone means the EU will step in if push comes to shove — the EU is assumed to have the political will. Similarly,though Britain’s public debt is spooky and its AAA credit rating is being questioned,London is supposed to have the political will to properly manage its debt.

But will there be enough political will? Those downplaying a sovereign debt problem now are not looking at the problem over time. Lenders need to feel that over the next 20 years or so necessary corrections will be made. Everyone’s favourite example is Sweden,which undertook a radical public debt surgery between 1993 and 2000. But a Goldman Sachs study shows the problem is tougher for some rich countries now. Britain,the study estimates,may need to make an adjustment (tax hikes and spending cuts) of up to 9 per cent of GDP to make public debt sustainable. That’s huge. The problem is worse for some other European countries and for Japan. A JPMorgan study on sovereign debt even talked about the possibility of Britain going for an IMF bailout.

An American Enterprise Institute study says of the US that its debt levels resemble those of other nations that have defaulted. True,America’s position is uniquely different (everyone accepts the dollar,too many people and institutions around the world hold US government bonds,the US is the biggest economy,so,no one therefore wants a run on US sovereign debt). But even America’s AAA rating has been questioned. And there’s no visible plan for fiscal adjustment in Washington. Given all this,the right question to be asked is whether markets will continue to believe there’s enough political determination over time to tackle the debt problem.

Some very well-informed watchers of global finance are arguing that public debt problems are almost certain. Willem Buiter,a senior Bank of England official who has just been hired by Citi as its chief economist,argued in his blog that we must see “the massive build-up of sovereign debt as a result of the financial crisis” for what it is: “(it is) all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default,perhaps dressed up as sovereign debt restructuring or even debt deferral.”

So,the point about the Dubai shake is that even if the sheikhs put together a bail-out (and call it something else),notice on the global debt problem has been issued from a desert city with an indoor ski-slope.

What about India,where public debt to GDP ratio is over 80 per cent and where tonnes of government bonds have been issued over the last 18 months? As it is for major Western countries or Japan,few are saying there’s an immediate problem. India in fact is perceived more like a high-debt Western country than a high debt emerging economy. Its high foreign exchange reserves,relatively stable exchange rate,high growth rate,all contribute to this assessment.

But like major rich world debtors,India has a big potential problem. However,note a difference. Most of India’s public debt is sold domestically and most of that is bought under fiat by sarkari banks. Very little official debt is sold to private sector foreigners or even to private domestic players. This means GoI doesn’t get the best deals on its debt. But many in India think that is okay because,in the absence of widely and privately held public debt,a sudden,sharp crisis won’t happen. They are wrong. Economic agents can still vote against India if its debt looks unmanageable. Credit ratings can come down sharply. Foreign investors can become wary. What India loses out on efficiency isn’t made up for by a false notion of safety.

saubhik.chakrabarti@expressindia.com