2010: the year of fiscal clean up

December 9, 2009

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- Jane Foley is research director at Forex.com. The opinions expressed are her own. -

At the height of the financial crisis few argued against the need for a huge fiscal and monetary policy response.  As a result the global economy has moved away from the precipice.  For many governments 2010 will bring a different kind of precipice, this will be the year in which many electorates will be made to start paying for their governments’ huge fiscal binges.

Certain countries will enter this process severely disadvantaged.  Earlier this year UK debt was singled out by S&P for a possible downgrade.  This week Moody’s commented that UK debt along with that of the US will test the boundaries of its top AAA rating.

The UK stands with the U.S., Ireland and Greece as being one of the few economies likely to register a double digit budget deficit/GDP ratio this year.  Fitch’s downgrade of Greece this week has propelled it into the spotlight.  This news followed the decision from S&P to put its sovereign rating on negative watch.

The news forced Greece’s Finance Minister to reassure markets that Greek bonds are accepted by the ECB after concerns rose over whether it would meet ECB collateral eligibility once temporary “emergency” rules revert to normal.

Some commentators have started to talk about sovereign default but this is not realistic within the G-10.  Others believe that governments will deliberately inflate away the value of their debt.  While this is also unlikely in a world where central banks tend to be independent and credibility can take decades to restore, it may also be also be hard to achieve in the immediate post crisis environment.

The U.S. and UK are experiencing a tightening of consumer credit which is a result of lessons learned from the subprime crisis.  Consumers are paying back debt and/or saving more to insure again potential unemployment or to make up for wealth lost during the crisis.

As a consequence, consumption is still facing severe headwinds; this means reduced pricing power for firms.  Eurozone banks were less exposed to subprime debt and consumers have a lower level of indebtedness.  However, the Eurozone savings rate has soared which should dampen consumption while the strong EUR should fend off inflationary pressures.

Along the lines of the BoJ in the 1990s, some central banks may find that their ability to create underlying inflation is lessened in the initial post crisis era.

It is not unprecedented for a country to turn around its fiscal position.  Sweden and Canada were success stories of the 1990s.  The first ingredient is a coherent government, the second is an electorate willing to accept austerity.

A third element relates to the structural efficiency of the economic infrastructure.  In order to join EMU, the budgetary criteria of the Maastricht Treaty had to be complied with.

Even it is the criteria were “fudged”, at the very least governments should have used the good growth years to soften the pain of reform.  Greece has fallen short on reform.  2010 will be a strong test for the Eurozone’s bad boys of Greece and Ireland.  If  budget austerity is not adopted promptly, the patience of other European countries may wear thin.

At this point, it seems unconceivable that a country could be thrown out of EMU and this view has stopped the spreads on Irish and Greece yield curves vs German paper from exploding.  That said, Greek spreads, already widened, lurched higher on the Fitch news giving the market a taste of what could be a rocky ride.  The longer the market doubts commitment to deficit reduction, the greater is the risk of volatility into the EUR.

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