Hayman Capital was one of the handful of US hedge funds that predicted the collapse of the US sub-prime market. But after watching how governments around the world moved to bail out their banks during the financial crisis, the hedge fund was quick to work out that government debt – particularly Europe, but also in Japan and the United States – was climbing to unsustainable levels. In an interview with Business Spectator, the firm’s global strategist, Richard Howard, talks about Europe, Japan and Australia.
Richard, what’s your current take on Europe?
We are still quite negative about the quality of sovereign credit in the medium-term. In the very, very short term, the situation is less negative than it was three months ago. The European Central Bank’s LTRO has had significant short-term impact. (The ECB has injected more than €1 trillion into the European banking system through its longer-term refinancing operation or LTRO.)
After the Greek debt swap, are other debt-heavy countries also go through a debt restructuring?
European officials like to portray the debt writedown in Greece as a one-off, but we think it’s created a precedent for other countries with intolerable debt burdens.
At the moment, the peripheral countries are cutting their budgets quickly and aggressively, which is having a negative impact on their economies and making it even harder for them to reach a balanced budget.
Greece was the badly behaved problem child, but it ended up with a giant debt writedown, and a massive bailout. There’s now a huge incentive for the Irish and the Portuguese to ask for the same. Both countries are seeing increasing internal political pressure to renegotiate the terms of their bailout packages. We’re not quite yet at the point where they’ll start threatening to refuse to cooperate, but we’re not far from that point. It’s certainly in their interest to follow the Greek example and seek a massive debt restructuring in order to stabilise their debt situation.
But I don’t think it’s realistic to think that the latest Greek bailout will stabilise Greece. When the Greek debt crisis started in early 2010, the country’s debt to GDP ratio was around 120%. It’s now close to 170%. The aim now is to get it back down to 120%. So almost three years later after a giant debt writedown and after hundreds of billions of euros injected into Greece, not to mention a wrenching change to the economy that has left one in five people out of work, they’re hoping to get the country back to where it was when the crisis first started.
At the same time, Portugal is where Greece was 12 months ago. But now we’re looking at potentially quite severe recession in the eurozone, whereas Greece benefitted from slightly less negative surrounding conditions in the region. As a result, private sector holders of Portuguese bonds are now looking to get out in advance of being penalised.
Then there is Italy, which is on a major media campaign to win over the marketplace. The new prime minister, Mario Monti, wants to deregulate the economy and create more growth. This is a laudable goal, but in the past we’ve seen governments consistently overestimate the benefits of policy changes on growth, at the same time that they’ve underestimated the negative market conditions.
Is the euro likely to survive?
Probably not in its current form. That is not to say that it disintegrates fully, but it has intractable problems that run to the very core. The biggest problem is the vast balance of payments imbalances between countries that is ultimately a function of a big divergence in competitiveness that has left countries like Germany and the Netherlands more competitive than the rest of the eurozone.
The natural solution to this imbalance in an optimal currency zone is a transfer of capital, labour and wealth within the borders. However, it’s clear that in Germany, the Netherlands and Finland, there’s no desire to pick up the tab for the financial problems in the eurozone. And the rest of the eurozone has no desire to have their budgets dictated by the Germans, the Dutch and the Finns.
Hayman Capital was one of the first observers to point to trouble ahead for Belgium and, more importantly, France.
Yes, Belgium is a country that has a huge debt burden (around 95-100% of GDP). It has a substantial fiscal deficit, and a fragile balance of payments. It also has a very large banking sector – banking assets domiciled in Belgium are around 3 to 3.5 times the country’s GDP. And the political tensions between the Flemish and the Walloons means that it’s now country that is fast running out of a reason to exist.
France also has a significant fiscal deficit and it has structural impediments to growth. On the positive side, its demographic profile is the best in Europe, but that’s not really saying much.
The biggest problem is that France has a substantial current account deficit – around 2.5 to 3% of GDP. And I think that’s the biggest ignored data-point about the eurozone. The French also have quite a large banking sector as well, which has a large exposure to the peripheral countries.
We tend to focus on the size of the banking sector because it indicates the level of support that governments may potentially have to provide, which has a direct impact on their credit rating.
I’m not suggesting that France will default in the next 12 months, but I think that their credit worthiness is a lot lower than what the market is currently rating it as, and that in certain specific circumstances, France could end up in the same situation as Portugal.
Will Italy manage to avoid a debt crisis?
Italy has the largest individual bond market in the eurozone, and the third largest in the world, so as goes Italy, so goes the eurozone.
I think that short-term, the ECB has created some stability by providing the banks with unlimited liquidity. But the basic problem is a solvency issue.
When a country has a very low growth rate, it’s very difficult for it to grow out of its debt problems. And typically the government sector in eurozone countries accounts for between 40% and 60% of the overall economy. So it’s doubly difficult to grow when governments are trying to cut their spending. We believe that markets have become far too complacent about sovereign debt risk.
What about Japan?
Japan’s debt to GDP ratio is the worst in the world yet the country’s interest rates are the lowest in the world, excluding Switzerland.
The primary reason is that for the past 15 years we’ve seen an excess of Japanese savings and a deficit of demand for those savings. So the Japanese government was able to issue debt without any competition from the private sector. But the Japanese demographic profile means that more workers are withdrawing from the workplace and drawing down their retirement savings.
The Japanese government is running a fiscal deficit of 10 to 11% of GDP. Spending on social security accounts for 27 trillion yen out against total revenues of approximately 45 trillion yen. In addition, the Japanese government has interest expense of 10 trillion yen. Add them both together, and the Japanese government is spending 90% of its total revenue on these two items.
We think that we are in the midst of an inflexion point, where there’s not enough Japanese savings to finance Japanese government debt. That means that the Japanese government will have to borrow in international capital markets. Given Japan’s risk profile – its debt to GDP ratio is 230% – Japan may have to pay, say, 3 to 3.5% to borrow. But that would push Japan’s interest expense to 30 to 35 trillion yen. We believe that is a recipe for disaster.
The Bank of Japan has announced that it will start buying a lot of Japanese government debt, which will temporarily allay the problem. But if the market starts thinking that Japanese inflation will pick up, interest rates will be pushed higher.
One other thing that has provided stability in Japan and solace for investors in Japanese bonds has been Japan’s consistent current account surplus. However beginning before, but obviously accelerating after the earthquake, tsunami and accident at Fukushima, Japan has seen its trade balance decline sharply. The reactor meltdowns and subsequent closure of the vast majority of nuclear plants has forced Japan to aggressively shift away from nuclear base load power. But that has meant it has had to pay a lot for LNG, oil and coal for its power generators.
Last year, Japan’s ran a full year trade deficit for the first time since 1980. The just released data for January show that Japan also ran the largest single month full current account deficit (in unadjusted terms) since the oil shocks of the 1970’s. In addition preliminary data show Japan on track for another trade deficit in February, despite it being traditionally the strongest month for trade performance.
Now, one of the things that the market relies on for Japan is that it is a net saver because it runs a current account surplus – take that support away and the market’s sentiment on Japanese debt sustainability could change very quickly and very aggressively.
We think a Japanese crisis is going to happen – there are some clear warning signs. And we think it will happen sooner rather than later. At present, the market view is that a Japanese crisis as an impossibility because there is so much committed capital that relies on stability that there is a cognitive bias and willful blindness to the risk that it will blow up in their faces.
Finally, Richard, as an Australian, how do you see the local market?
There’s no doubt in my mind there’s an asset and credit bubble in Australia, but it’s a lot more resilient than the asset bubble was in the US.
The Federal Government and the Reserve Bank have a lot of tools at their disposal. The Federal Government has a pretty clean balance sheet by world standards – thanks to very disciplined and prescient budget policy enacted by the previous government. That means that if it ever has to bail out the banks, it has the capacity to do so – something that not all countries can do.
The other thing is because almost everyone has a variable rate mortgage, if the Reserve Bank cuts rates, it flows through in terms of increasing the purchasing power of Australians and this can offset temporary stresses on households.
But sooner or later there has to be a reckoning. Australian real estate prices have grown out of line with the rest of the world and, more importantly, ahead of even the strong growth in Australian income.
If China has a medium-to-hard landing – and the China boom is not likely to extend past the next few years in its current form – the bloom will come off the Australian economy.
If people start losing their jobs, and are unable to pay their mortgages, it will start creating problems in Australia’s credit markets. That, in turn, could begin the process of finally rectifying the growing imbalance of debt to income in the Australian economy.
This article first appeared on Business Spectator