European and U.S. Fiscal Restraint a Threat to Growth: CIBC

Jul 28, 2011 | Corporate Member News

Greece Still Troubled; U.S. Debt Ceiling Deal Must Avoid Slashing Too Soon

Investors should hope that the U.S. approves an increase in America’s debt ceiling that doesn’t bring spending cuts or tax hikes in the near term, finds a new report from CIBC World Markets Inc.

“For the U.S. economy, investors should actually prefer an extension of the debt ceiling without the grand bargain on restraint, if the latter would impose significant cuts to spending or tax hikes in the near term,” says Avery Shenfeld, Chief Economist at CIBC. “America’s biggest challenge isn’t its deficit, but getting growth reignited to the pace at which the economy can tolerate a smaller role for government.”

Mr. Shenfeld notes that inaction on a long-term deal now will likely bring a downgrade from some rating agencies, but he doesn’t expect this will lead to a flood of Treasuries selling. Some institutions hold them under a mandated investment policy, but those rules typically specify that they hold Treasuries, rather than a triple-A instrument, so a downgrade will not entail a lot of forced selling.

Downgraded U.S. Treasuries will still be rated safer than Japanese government bonds, which manage to clear the market at only 1.1 per cent in the 10-year space. “The rating change would really only tell markets what they already know about U.S. debt and its status quo track,” adds Mr. Shenfeld.

“That was the case when Canada was hit with a downgrade by Moody’s in April 1995. At that time, there was no meaningful change in the trend for Canada-US 10-year spreads. Indeed, the turning point had already been reached in fiscal policy in the 1994 federal budget, one that would, a decade later, put Canada well ahead of the pack in debt loads.”

The situation is different in Europe where the markets cheered the announcement of Greece’s second bailout which removes, to a large extent, the risk of a near-term hard default on Greek debt. However, Mr. Shenfeld does not believe Europe’s deal will put the Greek debt issue to bed, and at best will delay the next panic only until Greece reports its inability to hit its fiscal and asset sales targets.

“The European leadership has allowed Greece a bit of debt relief. Some of that will be through an explicit cut in its outstanding debt, the rest through the present value of savings coming from lower-than-market rates on loans from the European Financial Stability Facility and the International Monetary Fund. All in, we estimate that Greece will save the equivalent of a roughly 20 per cent cut in the principal-no cure-all for a country approaching a 150 per cent debt-to-GDP ratio.”

There’s no quick fix or pain-free solution to Greece’s fiscal conundrum says CIBC’s Emanuella Enenajor. The only feasible option is a much steeper, painful haircut that would pare Athens’ debt to a more manageable level.

“A less appealing alternative would be a hard, one-time unilateral repudiation of its debt – unlikely, given potential EU retaliation, and other domestic costs. If Greece decided on its own to default, it would likely return to a new drachma, and benefit from a depreciated currency to help export its way back to growth. But with future revenues in devalued drachmas, Greek banks and businesses would also default on their euro-denominated liabilities, causing writedowns across the eurozone for nations exposed to both public and private Greek debt. That’s a risk that will keep EU leaders doing all they can to prevent a hard default by Athens.”

The lesson from the Greek situation is that investors will have to share in the pain of any new rescue packages in the region, a risk that will encourage private investors to pare back positions on eurozone peripheral debt and the euro in general. A softer pace of economic growth due to EU austerity measures also adds downside risk to the common currency.

Ms. Enenajor notes that while the second Greek bailout has allayed fears of an imminent default, there needs to be significant progress on austerity targets before any sense of calm can be justified.

“With indebted euro-area nations still facing elevated unemployment and weak domestic demand, fiscal tightening couldn’t be coming at a worse time. It may not take long for markets to fully realize that further explicit debt haircuts are the only escape hatch – suggesting downside for the euro and turbulence in investor confidence still ahead.”

The report notes that the leaders of the non-rescued European states have affirmed their “inflexible determination” to drive deficits below three per cent of GDP. This year alone, fiscal restraint will represent more than a one per cent drag on the region’s growth.

The complete CIBC World Markets report is available at:

CIBC’s wholesale banking business provides a range of integrated credit and capital markets products, investment banking, and merchant banking to clients in key financial markets in North America and around the world. We provide innovative capital solutions and advisory expertise across a wide range of industries as well as top-ranked research for our corporate, government and institutional clients.

For further information: Avery Shenfeld, Chief Economist, CIBC World Markets Inc. at (416) 594-7356, [email protected]; or Kevin Dove, Communications and Public Affairs at 416-980-8835, [email protected]

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