From the financial crisis to the debt crisis: Effects on the economy and financial markets

Investors’ Insight Vontobel Asset Management

From the financial crisis to the debt crisis: Effects on the economy and financial markets

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Preface

National debt in most developed countries will further increase in the coming 3 to 5 years. This is a direct conse­ quence of the debt relief (deleveraging) process for private households, which has only just begun. The situations are of particular severity in the USA, Great Britain and Spain, where the level of private debt – above all in the real ­estate sector – is notably high and real estate prices have fallen especially sharply. In this phase, if a country were to stand by idly on the sidelines, there would be, from an economic point of view, fatal consequences.

“As long as the private sector does not independently generate enough demand, the state must make up for this shortfall.”

The study is structured as follows: Chapter 1 presents a short historical overview, providing reasons for the emergence of the financial and real estate crises and explaining the particular significance and ne­ cessity of fiscal stimulus during real estate crises.

Chapter 2 explains why private sector and state debts are deferred and what effect this has on the economy and financial markets.

Chapter 3 presents the problems that arise as a result of high national debt.

Chapter 4 tackles the question of whether debt reduction is possible at all and, if so, under which conditions.

Chapter 5 deals with the problem of an aging population and its effects on national debt.

Such periods are characterised by below average econo­ mic growth and low interest rates and will last for several years. Only thereafter is it worthwhile reorganising the national budget and reducing debt. Successful examples even from recent history show which conditions allow a reduction of national debt and which do not. Finally, we are introducing a new indicator to assess countries’ bond risks the Vontobel Fiscal Risk Index (FRI). It demonstrates that bonds of certain ostensibly risky countries are today more attractive than those of countries which, at first sight, seem more reliable. This sets out a case for active management of bond portfolios.

Dr. Thomas Steinemann, Chief Strategist of the Vontobel Group

Chapter 6 demonstrates, by using the new Vontobel Fis­ cal Risk Index (FRI), which government bonds are seen by the market as being too negative and therefore are attrac­ tive from the investor’s point of view and which are not.

Chapter 7 presents conclusions for the investors.

Dr. Walter Metzler, Senior Economist

Dr. Ralf Wiedenmann, Head of Macro Research

March 2010 3

Chapter 1 What exactly is the problem in a housing crisis? Private debt!

Real estate makes up a substantial proportion of per­ sonal assets in many countries. It is estimated that in the USA securities including pension assets make up on average roughly 66% of personal assets, yet real estate accounts for up to 30%. Real estate is typically financed to a large extent with mortgages, which are often still state-subsidised. In the USA, owning your own home is strongly encouraged, and indeed in the mid 1990s the Clinton administration actively promoted home owner­ ship (see Diagram 1). In the course of rising real estate prices, the banks joined along with a lending policy which was too lenient: the seeds of the “subprime crisis” had been sown.

Diagram 1: USA – Proportion of home-owning households in %.

Diagram 2: Fiscal balances of the private sector, government and foreign trade must always balance.

10%

USA: sector financial balances in % of GDP

8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 Private Balance

70 69

General government balance

Capitol account balance

Sources: Federal Reserve Flow of Funds, Vontobel

68 67 66 65 64 63

85

87

89

91

93

95

97

99

01

03

05

07

09

Rate of home ownership

loans, which investment banks then began to repackage and resell. But the state also profited from high tax reve­ nues. High national debt in many countries in the mid 1990s was able to be reduced substantially right up until the outbreak of the financial crisis in 2007 (see Diagram 5). The US Federal Reserve’s policy of low interest rates under Chairman Alan Greenspan finally added fuel to the fire – even if it was unintentional – and further acceler­ ated the hectic activity.

Sources: Datastream, Vontobel

Thus it is not by chance that in the mid 1990s there arose a large increase in private debt in American households.

In Diagram 2 it is possible to see that until the mid 1990s there were net savings in the private sector (the red bars in positive territory); thereafter, however, there began to be debts (the red bars in negative territory).

However, the total increase in private debt since 1997 is not exclusively linked to property ownership and thus mort­ gages. But the attractive property prices since 1997 (see Diagram 3) and the Clinton policy were a cocktail which the banks also went along with and which led to a lenient lend­ ing policy and especially a lenient mortgage lending policy.

As long as house prices continued to rise, this was a “win-win situation” for everybody: the rising value of real estate meant that the lending ratio could be in­ creased further (“home equity extraction”). This had pos­ itive effects on consumption as well as economic growth.

Private households” balance sheets were swelling: the ­a ssets side through rising real estate values and the liabili­ ties side through growing debt. Banks could issue more 4

When real estate prices in the USA started to fall in 2007 the whole process went into reverse. Falling real estate prices forced and continue to force households to reduce debt and limit consumption. Private individuals must shrink the size of their balance sheets. Debt reduction and the resultant move away from consumption led to recession. In this situation, the state only has two pos­ sibilities: either do nothing and risk a deep depression with unemployment reaching perhaps 30%, or increase government expenditures and in doing so compensate for some of the shortfall in private consumption and invest­ ment. The harsh experience of the 1930s demonstrates, however, that it is entirely correct to choose the second option and to accept – temporarily – increasing deficits and national debt. Nevertheless, the state cannot deny a share of the blame for the financial and debt crises: given the fact that many states promoted home owner­ ship financed through debt; and given the de facto state guarantee of large banks, states do without a doubt bear partial responsibility for the current crisis.

Alongside that of households, part of “private debt” is that belonging to companies and financial institutions.

Together with national debt these three areas make up a countrys’ total debt. The total debt of selected countries (as at the end of 2008) was as follows (see Diagram 4):

sions concerning possible “state bankruptcy”, effects on economic growth or interest rates are to be drawn. This topic will be picked up again in Chapter 3 and 6.

It is striking that not all countries which have a high level of total debt also have a high level of national debt.

Spain, South Korea and Switzerland are examples of this.

For instance, Spain, which is currently considered to be another eurozone crisis candidate, has a lower level of na­ tional debt than Germany. In contrast, the USA, Canada, Great Britain and Spain have high levels of private house­ hold and corporate debt which must be reduced in the near future. Although Switzerland has the highest level of private household debt (118% of GDP) compared to the countries analysed, the pressure there to take correc­ tive action is less pronounced because the quality of the debt is higher (high levels of household financial assets, careful lending policy, longer periods during which fixed interest rates are locked in). Additionally, in the USA, Great Britain and Spain the commercial real estate sector is under pressure. In Spain this is also true for parts of the commercial sector as well as banks. It is also striking that all sectors in the major emerging markets like China and Russia have low levels of debt. Consequently, a distinc­ tion between the different meanings of the term “indebt­ edness” from country to country is necessary if conclu­

Diagram 3: Property prices in the USA and land prices in Japan.

300

250 Japan

200

USA

150

100

50

80

82

84

86

88

90

92

JP LPI: 6 big Cities NADJ

94

96

98

00

02

04

06

08

US S&P/Case-Shiller home price index 10-City Composite NADJ

Source: Datastream, Vontobel

Diagram 4: Distribution of debt across four sectors in selected countries.

52

400

333 37

101

114 96

136

115

101

101

82

67

84

Switzerland

108

69

81 44

South Korea

75

Spain

108

Japan

UK

50

UK adjusted

113

273

60

245 60

118

85

202

290

78

110

150

0

299

73

75

200

100

308

81

40 77

96

56

66

54

158 32

66

62 84 76

142

96

47

12 18

30 13 33

129 66

71 5

40

42 10 11

10 16

Russia

314

India

28

Brazil

47

China

343

Canada

188

Germany

52

300 250

Non-financial Business Government

380 114

US

350

Financial institutions Households

459

Italy

450

469

France

% of GDP 500

Source: Mc Kinsey Global Institute 5

Chapter 2 Effects of private debt on the economy and financial markets: interest rates remain lower than expected

Falling real estate prices and the resultant need to reduce debt have led to the private sector in the USA once again becoming, for the first time since the middle of the 1990s, a supplier rather than a consumer of capital to the extent of 6% of the GDP (see the red bars in Diagram 2). In turn, the state was more readily able to increase its expenditures, and the deficit reached around 10% of GDP in 2009 (the blue bar in Diagram 2).

Reduced demand for capital from both the public and pri­ vate sectors has made a significant contribution to lower in­ terest rates on the capital markets than before the financial crisis in spite of the level of borrowing by the state. There­ fore, as long as we find ourselves in a debt-reduction pro­ cess (balance sheet recession), then it can be assumed that, owing to high capital supply, interest rates will remain lower than widely expected. The case of Japan demonstrates this clearly. Land prices there have fallen continuously over the past 20 years since the bursting of the housing bubble (see Diagram 3), which has meant that companies must use their income for ongoing debt reduction.1 So there was very little capital remaining for investment and consump­ tion. This was one reason for the prolonged weak eco­ nomic growth in Japan. The effects of debt reduction led to a sharp increase in the supply of domestic capital, interest rates remained low, and foreign investors financed only a very small portion of the Japanese debt at 7%.

Studies show 2 that the process of state debt reduction be­ gins on average two years after the outbreak of a financial crisis and lasts for six to eight years. This may possibly be longer for the present crisis. The reason is linked to the fact that, in the past, exports played an important role in eco­ nomic growth; as a result of the global dimension of debt – with the exception of the emerging countries – a simul­ taneous expansion of exports is unlikely. The International Monetary Fund (IMF) suggests that the national debts of many developed countries will continue to rise until 2014.

This assumption seems realistic. During a private debt-re­ duction process, the state must step in with fiscal stimulus to prevent a deep recession, and it can only then set about reorganising the state budget. Consequently it would be wrong to aim to reorganise the state budget too early. This should happen only once the private sector is once again in a position to generate enough demand. The phase of pri­ vate debt reduction is thus characterised by an increase in national debt. Moreover, it has been shown – also in Japan – that economic growth is weak during a period of private debt reduction and only recovers gradually.

1 In

We expect to see lower rates of economic growth, in par­ ticular in those countries which have above average private debt (see Diagram 4). This relates to Spain, Great Britain, the USA and South Korea.

Japan, in contrast to the USA, it was mostly companies which held debt.

Kinsey Global Institute, “Debt and Deleveraging: The global credit bubble and its economic consequences”, January 2010.

2 Mc

6

Thus we expect that the private debt-reduction process will take up the next three to five years. In this phase – let us call it Phase 1 – private debt is reduced, yet national debt rises as a result of compensating for lower demand. Eco­ nomic growth is actually positive thanks to fiscal stimulus but is clearly below average, and interest rates rise only slightly due to the supply of capital. Only afterwards, in Phase 2, should the actual reorganisation of debts start to be taken on. Phase 2 should begin when private debt has returned to a reasonable level and – as a prerequisite – when asset prices and, most importantly, real estate prices have stabilised. This is the condition required in order for “Japanese circumstances” to be prevented. We assume that the USA will not follow Japan’s example because, ­according to Robert Shiller, who created the well-known US home-price index and gave an early warning of the real estate bubble, after a 30% correction, US real estate prices correspond roughly to their true value.

Chapter 3 Do national debts even need to be reduced?

There are no clear scientific rules to determine how high national debt may rise. There is a generally accepted principle that economically productive investments such as roads and schools may be financed with debt. This is because, as a rule, these investments increase growth and in the process more or less finance themselves. In contrast, expenditures to boost consumer spending – such as public-sector wages, subsidies or the transfer of wealth for social purposes – should be financed through current taxes. This also complies with the principle of fairness be­ tween generations.

There are multiple reasons for avoiding an excessively high level of indebtedness. The larger the debt, the higher the risk that the capital markets will demand a higher risk premium in the form of interest rates – as is happening currently in Greece and other southern European coun­ tries. With rising interest rates, the danger of a debt spiral also increases at the same time because higher interest rate payments inflate the deficit. A debt spiral then occurs when interest rates are higher than the growth of nominal GDP. In order to avoid a debt explosion in this situation, a surplus in the primary budget (the budget excluding inter­ est payments) must be achieved.3

Alongside a debt ratio of 60%, the Maastricht Treaty stipulates a maximum deficit ratio of 3%. This arises from the fact that the architects of Maastricht took as their starting point growth of nominal GDP of 5% (for exam­ ple, 2.5% real economic growth and 2.5% inflation). At this potential growth rate, the debt ratio stabilises at 60% if the deficit amounts to 3% on average. If growth is 4%, the deficit can only be 2.3% of GDP in order to keep the debt at 60%. In the opposite case, growth of 6% would, for example, permit a deficit of 3.4%.4 According to a new study by Reinhart and Rogoff 5, eco­ nomic growth significantly worsens starting at a level of debt of 90% of GDP. In 20 industrialised countries in the period between 1946 and 2009, no negative influence on growth as a result of low levels of debt was perceivable.

With levels of debt of over 90%, however, growth turned out to be lower by 4 percentage points. Lower growth further impedes the reduction of debt. With regard to inflation, there seems to be, interestingly enough, no con­ nection between levels of debt and economic growth.

See the Appendix for an explanation of the connection between interest rates, primary budget and economic growth.

Diagram 10 in the Appendix presents all of the combinations of budget deficit and economic growth which can keep national debt constant at 60%.

5 C. Reinhart and K. Rogoff, “Growth in a Time of Debt, Working Paper for AER Papers and Proceedings”, 2009.

3 4

7

Chapter 4 Can national debt be reduced at all?

Essentially, a high debt ratio can be reduced by high growth, restrictive financial policy, a certain amount of inflation or, in extreme cases, by defaulting. For devel­ oped industrialised countries which have not suspended debt repayments since World War II, bankruptcy is no viable way of discharging their debts because they would be shut out of the international capital markets for a long time afterwards.

For similar reasons, hyperinflation as a way out is, in prac­ tice, ruled out. Almost all cases of hyperinflation in indus­ trialised countries happened after abandoning the gold standard. Today the capital markets would punish such attempts with very high risk premiums. Additionally, many central banks are independent and are committed to price stability. In order to substantially increase inflation, the corresponding laws would first have to be changed (ex­ cept in Great Britain where the Chancellor of the Excheq­ uer sets the inflation target).

A moderate rise in inflation appears likely, however, and it also plays a part in reducing the debt ratio. A target inflation of 2%, as is prescribed by the ECB, is also, with regard to the debt problem, a sensible value and would contribute to debt reduction. It is possible that temporary rates of 3% are tolerable. What is certain is that price stability cannot be treated carelessly. The credibility of central banks is a high-value asset but one which can very quickly be squandered, and without it monetary policy would become undermined and ineffective. For this rea­ son, the proposal by the IMF Chief Economist to aim for an inflation target of 4% is also counterproductive and should not be supported.

Accelerated real growth is without doubt the “silver bul­ let” of debt reduction because other economic targets can also be achieved as a result. The experiences of coun­ tries such as the USA in the post-war period, Ireland and northern European countries such as Denmark or Sweden in the 1990s demonstrate this. Yet this approach is im­ peded because of private debt reduction and the relatively low expectations of real growth.

Fiscal policies such as stopping the expansion of debt or the Maastricht criteria have proven to be helpful. In con­ trast to the widely accepted view, substantial cuts on the expenditures side during periods of consolidation have actually proven to be particularly effective because the long-term growth rate increases. The reason is linked to the fact that a reduction in expenditures permits a de­ crease in distorting, growth-hindering taxes. During the period between 1960 and 2000 in 22 industrialised coun­ tries which had opted for this approach, the long-term growth rate increased by 1.5% for every 10% reduction in the expenditure ratio.

Of particular note is the case of Sweden which, along­ side other Scandinavian countries, likewise dealt with a real estate crisis at the beginning of the 1990s (see Box) and successfully began to reorganise the state budget after the end of the slump in the real estate market. The Scandinavian countries also managed to simultaneously implement reforms in the labour market which increased the participation rate and productivity. Alongside low expenditures, economic growth rose as a result, as did tax revenues.

Diagram 5: Debt reduction in selected countries.

120

Debt ratio in % of GDP 102

100 84 80

72 65 58

60 40 20 0

44

8

47

32 14

Australia 1995–2008

Uk Switzerland USA 1982–1990 2004–2008 1993–2000

Sources: OECD, Vontobel

Thus, a realistic approach to reducing debt continues to be found in austerity measures. The issue here is to create surpluses in the primary budget and maintain them over a long period of time. As can be seen from Diagram 5, suc­ cessful consolidation efforts require several years, though they are possible.

54

51 43

Sweden 1996–2008

Canada 1996–2007

Successful debt consolidation after a financial crisis. Sweden’s experience 1996 – 2008 – Huge budget deficits between 1992 and1994 to over­ come the banking crisis – From 1994: savings programme, liberalisation of the right to terminate employees accompanied by active labour market policy –> unemployment falls in parallel with dept reduction from 11.3% in 1994 to 6.2% in 2008 – Taxation ratio fell during the consolidation period from 60% of GDP to 54% – Productivity growth increased: between 1996 and 2008 it meausured 2.0% p.a. compared with 1.6% between 1976 and 1995 (while national dept increased from 26.1% to 84.4%

– Strict budget consolidation in 1996 (full 4 percent­ age points of GDP) leads to an unparalleld collapse in growth (4.2% to 1.5%) – Curtailment of tax increases and wealth transfers, no automatic adjustements for inflation – Afterwards the economy recovers quickly (in the con­ solidation phase, the economy grows in real terms by 2.8% p.a., while the growth of national dept between 1976 and 1995 is only 1.6%)

in % of GDP 5

90

4.5

85

4

80

3.5

75

3

70

4

5

2

4

0

3

-2

2

2.5

65

-4

1

2

60

-6

0

1.5

55

1

50

0.5

45

0

96

97

98

Sources: Datastream, Vontobel

99

00

01

02

03

04

Balance of the primary budget, cyclically adjusted

05

06

07

08

40

Public-sector debt (r.h. scale)

-8

Debt consolidation

-10 -12

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

-1 -2 -3

Real GDP (% YoY, right scale) General government balance in % of GDP

9

Chapter 5 Demographics and its effects on debt

Secondly, expenditures for pensions, health care and nurs­ ing will increase. In the European Economic and Monetary Union (EMU) between 2010 and 2060 this increase will constitute roughly 5% of GDP. Without countermeasures, the demographic burden will cause the level of debt in the EMU to grow from around 80% to 420% by 2060.

Switzerland can expect to see debt levels increasing from roughly 40% of GDP today to around 120% by 2050, which is lower but still very high. Social welfare institu­ tions would see debt rise more than Federation, canton and commune.

Diagram 6: Economically active population in Switzerland: ­decreasing from 2020.

4 000000 3900000 3800 000 3700 000 3600 000 3500000 3400 000

2010

2020

2030

2040

Source: Swiss Federal Finance Administration (FFA), April 2008

10

Diagram 7: Increasing levels of debt owing to demographic de­ velopments in Switzerland without countermeasures being made.

140 120 100 80 60 40 20 0 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050

Finances due to the financial and economic crises appears almost modest in comparison to the risks posed by de­ mographic aging. The burden of an aging population may well only be felt relatively far off in the future, but it can be almost certainly predicted. The demographic burden will come about firstly because the active population in Europe will shrink between 2020 and 2050 (see Diagram 6 for the Swiss example). This will reduce growth and tax revenues.

Source: Swiss Federal Finance Administration (FFA), April 2008

In the USA, the burden of an aging population on public finances is less pronounced than in Europe because the entry of young immigrants into the country has affected the age structure in a less negative way. Without imple­ menting countermeasures, debt will nevertheless rise to a full 100% of GDP between 2010 and 2060. However, it is important that the effects of demographics on debt – if no countermeasures are taken – will only become obvious at some stage in the distant future and thus should not become intermingled with the current debt crisis.

Chapter 6 Implications for investors in the bond sector: Introducing the Vontobel Fiscal Risk Index (FRI)

This chapter seeks to investigate whether different levels of attractiveness can be established in the market for government bonds. To this end, countries’ fundamental fiscal situations are assessed by using a proprietary index which we have developed. This index, called the Vontobel Fiscal Risk Index (FRI), not only assesses countries accord­ ing to their level of debt or budget deficits as is often the case; rather, it assesses them according to a total of seven indicators which are relevant in painting a comprehensive picture of a country’s fiscal risk. Thereafter this “true”

The following factors are incorporated into the ­“Vontobel FRI”. In our opinion they are the relevant ­factors for a comprehensive assessment of fiscal risk.

1. Current level of debt. The higher the current level of debt, the worse the assessment, and vice versa.

2. Cyclically adjusted primary budget. The higher the predicted primary budget deficit, the lower the chance of a reduction of debt, and vice versa.

3. The ratio of current nominal interest rates to expected nominal GDP growth. The higher the interest rate in relation to expected nominal economic growth, the greater the risks of a debt explosion.

assessment will be compared with the risks priced in by the market as measured with credit default swaps (CDS).

In this way, it can be established which government bonds have too much risk in their pricing in relation to their “true” fiscal risk. These are attractive bonds for the investor. In contrast, some countries’ risks are underesti­ mated by the market, and these bonds are better avoided.

Finally, there are risks which are more or less “correctly” valued by the market.

4. Current account deficit. The higher the deficit, the higher the level of capital injections from abroad and thus the more susceptible the country is to the flight of capital, and vice versa.

5. Growth in productivity. The lower the growth in pro­ ductivity, the more difficult debt reduction becomes, and vice versa.

6. Have there been previous consolidation successes?

The less often successes have been achieved in the past in generating budget surpluses, the lower the chances that they will be achieved this time.

7. Average maturity of national debt. The shorter the maturity of national debt, the more rapidly high inter­ est rates will have an impact on interest expense, and vice versa.

11

These seven factors will be established for each country (data sources: OECD, IMF, Bloomberg) and provided with a weighting.6 In this way, a risk value, we compare with the marketprices for the risk (CDS Spread), for each country can be calculated (see Diagram 8). Table 1 in the Appendix also provides a detailed evaluation of each country.

The following results are striking: in reality, Greece presents a high fiscal risk (FRI of 5.7), which is surpassed only by that of Portugal and Japan (FRI of 6.9). What is certainly very interesting is that the negative assessment of Greece in accordance with the FRI is not only already incorporated in prices, but rather Greece is even evaluated too negatively. This is because the ascending line in Dia­ gram 8 shows the area of fair valuation. Greece is posi­ tioned very far away from this line, which suggests that it is an interesting investment opportunity. The same is true, albeit to a lesser extent, for Ireland, Portugal and Sweden (countries in the green area). Countries which we consider to be valued correctly and all of which are positioned near to the fair value line (the white area in Diagram 8) include,

for example, Switzerland, Great Britain, Spain and, just barely, the eurozone countries taken as a whole. In the case of Germany, the Netherlands, Japan or the USA, in contrast, the CDS spreads are, according to our analysis, too low for the risks which in reality exist (the red area in Diagram 8). Government bonds from these countries can consequently be considered less attractive investment op­ portunities because they entail more risk than the market price suggests. This may be connected with the fact that these countries (except Japan) all have a AAA rating, which is underestimating and thus distorting the actual fiscal risks.

According to this analysis, the market can be seen to be temporarily evaluating some “true risks’ incorrectly so that there is a possibility for active investment decisions.

Govern­ment bonds from Greece, Ireland, Sweden and Portugal appear as attractive purchase opportunities.

Market distortions also come about, in our opinion, as a result of ratings agencies, which lead to a distortion of market prices; the “true” risks are particularly for the USA, Japan and Germany higher than the CDS spreads suggest.

Diagram 8: CDS spreads and Vontobel Fiscal Risk Index: Greece is valued too negatively by the market.

300

Grecce

CDS Spread

120

Ireland

100

Spain Italy

80 EMU

UK

0

Australien

Danmark

2

Belgium

Switzerland

Sweden

20

Finland

3

Netherlands

USA Germany

4 5 Vontobel Fiscal Risk Index

Sources: Bloomberg, CMA, IMF, OECD, Vontobel, CDS spreads as at 15 March 2010

12

Japan

60 40

6

Portugal

The composition of each country’s FRI can be seen in Table 1 in the Appendix.

6

7

Chapter 7 Conclusions for the investor

1. Economic growth over the next three to five years (Phase 1) will remain positive, although clearly below the potential growth rate. The reason is that this period is characterised by the private debt reduction of compa­ nies, private households and financial institutions – each depending on the country concerned. To compensate for reduced demand, the state is increasing its debt. In a sec­ ond phase – from around 2014 onwards – the process of reorganising national budgets can be started. This Phase 2 could take up to 10 years or more.

“Active management is more sought after than ever.”

2. Due to “deleveraging” in the private sector, net capital will be offered in the developed countries. This keeps interest rates lower than has been widely assumed. The risks of either a rise in interest rates or inflation exist predominantly in the transition period into Phase 2. This would then be the case if demand were to increase again and the liquidity created had not been absorbed correctly by the central banks, resulting in the risk of a steep rise in inflation. Earnings on shares are expected to be positive in Phase 1, though lower than the historical average. Bonds are expected to produce lower yields of between 0% and 2%, possibly even producing negative earnings in Phase 2.

3. Over the coming years, “tectonic shifts” lie in store in the area of debt development, in monetary and fiscal policy, in shifts in power from West to East as well as in terms of demographic shifts. For this reason, static in­ vestment concepts are not advisable for either private or institutional investors. In fact, to recommend otherwise would almost be tantamount to negligence. Both types of investors cannot fail to regularly examine their strategic asset allocations. Even in the field of tactical investment policy, an increased number of opportunities exist for ac­ tive cultivation and management of portfolios – as shown in the example of the Vontobel Fiscal Risk Index. In view of the enormous challenges in the coming years, we can no longer assume that the financial markets will produce high yields or that it is advisable to simply hold an invest­ ment. Staying with the example of the bond markets: does a passive investor really want to buy more bonds in countries that must issue more and more bonds because they can’t keep their own house in order?

13

Appendix

cal policy rather than the entire budget deficit. Because interest payments cannot be changed by fiscal policy, budgetary reorganisation measures must be set using the primary budget (the budget without interest payments).

Interest rate, primary budget and GDP growth It is often asked why the primary budget (the budget without interest payments) is used for evaluating fis­ Diagram 10: Budget deficit in % of GDP to achieve a debt ratio

For a balanced primary budget, interest payments corre­ spond exactly with the budget deficit. Given a debt ratio of 100% of GDP, an interest rate of 5% produces a defi­ cit of 5% of GDP. The debt also grows by exactly 5%. If GDP growth is also 5%, the debt ratio therefore does not change. If, on the other hand, GDP growth is less than 5%, the debt ratio increases.

of 60% of GDP as a function of nominal economic growth.

5.0% Budget deficit to GDP ratio

4.5% 4.0% 3.5%

Maastricht Treaty target

3.0% 2.5% 2.0% 1.5%

Nevertheless, if the state wishes to hold the debt ratio constant, it must create a surplus in the primary budget.

If growth only reaches 2% and the interest rate is at 5%, the surplus in the primary budget must be 3% of GDP in order to keep the debt ratio constant.

1.0% 0.5% 0.0%

0%

1%

2%

3% 4% 5% Nominal GDP growth

6%

7%

8%

Source: Vontobel Table 1: Vontobel Fiscal Risk Index (FRI) Debt/GDP 2010

Weightings

Cyclically ­adjusted pri­ mary budget ­balance 2010

Annual ­productivity growth 2000–2010

Interest rate – nominal GDP growth rate 2010/2011

Past large ­fiscal improve­ ments*

Current ­account ­deficit 1998–2008

Average ­maturity of debt

Vontobel ­Fiscal Risk ­Index

0.30

0.15

0.10

0.15

0.05

0.10

0.15

Sweden

2

3

2

0

0

2

4

2.1

Denmark

2

5

6

0

3

4

0

2.5

Finland

2

4

4

1

5

2

10

3.7

Switzerland

2

3

6

9

8

0

3

3.9

Australia

1

3

4

7

8

7

8

4.5

Canada

4

6

7

0

6

4

7

4.6

Netherlands

3

4

6

6

8

2

7

4.7

Great Britain

4

10

4

6

7

6

0

5.0

Belgium

5

2

6

7

6

3

6

5.0

Germany

4

4

6

8

6

3

6

5.1

USA

4

10

1

0

8

7

8

5.1

EMU

4

5

7

8

7

5

5

5.5

Italy

6

1

10

9

7

5

2

5.5

Ireland

4

10

2

10

2

5

3

5.5

Spain

3

7

6

9

8

7

3

5.5

Greece

6

10

0

7

5

9

1

5.7

Portugal

4

6

6

8

7

9

4

5.8

Japan

9

9

5

4

7

3

7

6.9

This table shows the Vontobel Fiscal Risk Index and the sub-indices. A higher value means a greater risk. The index ranges from 0 (very low risk) to 10 (very high risk). CDS values are for 15 March 2010.

Sources: OECD, IMF, Bloomberg, Vontobel *”Cyclically Adjusted Primary Balance” according to IMF since 1985.

14

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