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| A Sideways Glance - Par Bonds |
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As we enter a phase of introducing austerity packages to tackle the Western world’s high level of indebtedness, leaders could well learn from Canada’s crisis in 1994 where order was achieved to restore fiscal discipline.
Balancing the books
In the early 1990’s Canada’s federal deficit was running at over 8% of GDP while the national debt reached 70%. The Mexican crisis in 1994 helped illustrate the urgency of the austerity measures required to control Canada’s deficit and the resultant budget trimmed departmental spending by 5% while cuts to grants and subsidies were more widespread and cut deeper. Helped by a number of factors such as low interest rates, a rebounding global economy and a weak currency they were able to balance the books within 3 years.
Across Europe we have a similar dilemma with austerity packages either being implemented or at discussion stage. Debt levels across most Western economies are extremely high and these countries need to maintain a balance of implementing deep fiscal cuts while focusing on domestic growth. It is this fundamental balance that many euro-zone countries are struggling to establish. “The bank of Italy last week estimated that the effect of the austerity package would be to reduce the country’s already anaemic growth by 0.5%.” In effect the packages could push Italy back into recession and this could certainly happen in Greece and many other European nations.
In the UK, figures published in April 2010 highlighted that our public sector net debt was £890 billion or 62% of National GDP. Our own austerity package will be announced very shortly and I’m sure elements of higher taxation combined with deep public sector cuts will cause controversy and protest. However, similar to the Canadian example we have a low interest rate environment and a depreciating currency, however the level of growth remains in question and we must comprehend that sustainable debt reduction is extremely difficult in the absence of growth.
The UK Position
While the UK position is not great by any stretch of the imagination, it is likely that the government will push through tough measures and we will manage the debt repayments. The situation for the peripheral European countries is much worse however. Despite the hard talk from Greek politicians the resultant riots in Athens, the austerity package is probably not enough. At some point the debt will need to be restructured in order to avoid a default. One option which was first initiated by the Japanese in the late 1980’s, is to issue par bonds, which is essentially issuing bonds with a similar face value but with much longer maturities and lower coupons, and therefore, a lower real value.
Fundamentally we could see par bonds implemented across much of Europe and possibly the Western world. The issuance of par bonds reduces the huge debt burden to individual Governments as the cost of financing this debt is reduced while also reducing the worry about refinancing in the short to medium term. It is also preferable for the banks and other financial institutions that have lent the money simply because they maintain a viable asset on their balance sheet while supporting the overall economy.
It is fascinating how history repeats itself. We have written previously about the dilemmas of the Persian king in 1752 BC who could inflate, deflate or include concessions in writing off the debt. The UK Government during World War II issued War Loan for the purpose of financing military operations. This went even further than par bonds in that it didn’t even have a maturity date – and 70 years later it is still being traded.
Once again it appears that history is repeating itself and that human behaviour continuously moves in cycles!
Andrew Heath 21.06.10 Sources:
Office National Statistics
Wolfgang Munchau – Financial Times Monday 14th June 2010 |
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