by Don Alexander , MBA
Associate, RSS Solutions Inc.
Fiscal positions in many economies were on an unsustainable path before the financial crisis. The crisis led to a further deterioration in fiscal sustainability by increasing fiscal deficits and debt. As a result, financial markets and credit rating agencies took a more critical view of sovereign credit risk. Government debt and deficits that had been tolerated before the crisis were no longer considered sustainable. The BIS looks at some of these issues and potential risks in their 82nd Annual Report in a chapter called Restoring Fiscal Sustainability.
Sovereigns under fiscal pressure have been losing their risk-free status, as reflected in sovereign credit default swaps (CDS) spreads and credit rating downgrades. The broad availability of safe assets aids the operation of financial markets and the conduct of monetary policy. And a sovereign whose debt is essentially free of credit risk has ample room to implement countercyclical policies to support macroeconomic stability
This has generated concerns sovereigns losing their risk-free status or, more specifically, about their liabilities becoming subject to non-negligible credit risk. To be sure, even from this narrow perspective, full risk-free status is an ideal goal rather than a realistic objective. Indeed, the worst possible outcome is treating an asset as risk-free when, in fact, it is not. The existence of such assets contributes to the smooth and efficient functioning of the financial system.
Restoring the supply of risk-free assets requires that governments convincingly address high deficits as well as projected increases in their long-term liabilities. Governments will have to significantly improve their fiscal balances to put their finances on a sustainable path and restore confidence in their fiscal positions. Fiscal consolidation has started in anumber of economies, but more needs to be done. Nevertheless, many of the countries that implemented deficit reduction measures were not able to meet their headline deficit-to-GDP targets.
Financial markets can both help and hinder the return to fiscal sustainability. On the one hand, market discipline can provide incentives for fiscal consolidation. On the other, financial markets can remain complacent about fiscal problems for too long and react too late. Policymakers should therefore not wait for market signals to emerge in order to engage in fiscal consolidation.
Governments should implement pension and health care reforms now while reducing the long-term contingent liabilities to bolster confidence in the long-term sustainability of public finances. Countries must implement reforms and delaying fiscal consolidation could weaken confidence, leading to higher borrowing costs. Policy recommendations differ as to the best timing of fiscal consolidation. It is important for policymakers to manage the expectations of investors and financial markets by encouraging them to look beyond the very short term. This means communicating clearly about the likely impact of planned fiscal consolidation measures at various horizons. Structural policies, including product and labor market reform, are especially important. They can facilitate the reallocation of resources, support competitiveness and boost productivity growth.
Longer-term, policymakers need to take measures to break the link between the banking sector and sovereign risk. One step is encouraging banks to build capital and liquidity buffers – a priority of the regulatory reforms under way – which would reduce the probability those governments would have to bail them out again. Fiscal positions were already unsustainable before the financial crisis, which in turn led to significant further weakening. The deterioration of public finances has undermined financial stability, lowered the credibility of fiscal and monetary policy, impaired the functioning of financial markets, and increased private sector borrowing costs. Restoring sustainable fiscal positions will require implementing effective fiscal consolidation, promoting long-term growth, and breaking the adverse feedback loop between bank and sovereign risk. Otherwise, risk managers will remain busy managing exposures.
For more on this follow the link: www.bis.org/publ/arpdf/ar2012e5.htm
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