2010 vontobel paper

8/8/2019 2010 Vontobel Paper

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I n v e s t o r s

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i g h t

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t o b e l A s s e t

M a n a g e m e n

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From the nancial crisis to the debt crisis:

E ects on the economyand nancial markets


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Disclaimer Although Vontobel Group believes that the in ormation provided in this document is based on reliable sources, it cannot assume responsibility or the quality, correctness, timeliness or completeness o the in ormation contained in this report. This document is or in ormation purposes only andnothing contained in this document should constitute a solicitation, or o er, or recommendation, to buy or sell any investment instruments, to e ectany transactions, or to conclude any legal act o any kind whatsoever.This document has been produced by the organizational unit Asset Management o Bank Vontobel AG. It is explicitly not the result o a nancialanalysis and there ore the Directives on the Independence o Financial Research o the Swiss Bankers Association is not applicable.No part o this material may be reproduced or duplicated in any orm, by any means, or redistributed, without acknowledgement o source andprior written consent rom Bank Vontobel AG.


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Pre ace

National debt in most developed countries will urther increase in the coming 3 to 5 years. This is a direct conse-quence o the debt relie (deleveraging) process or privatehouseholds, which has only just begun. The situations areo particular severity in the USA, Great Britain and Spain,where the level o private debt above all in the realestate sector is notably high and real estate prices have

allen especially sharply. In this phase, i a country wereto stand by idly on the sidelines, there would be, rom aneconomic point o view, atal consequences.

As long as the private sector does not

independently generate enough demand,

the state must make up or this short all.

Such periods are characterised by below average econo-mic growth and low interest rates and will last or severalyears. Only therea ter is it worthwhile reorganising thenational budget and reducing debt. Success ul examples

even rom recent history show which conditions allow areduction o national debt and which do not. Finally, weare introducing a new indicator to assess countries bondrisks the Vontobel Fiscal Risk Index (FRI). It demonstratesthat bonds o certain ostensibly risky countries are todaymore attractive than those o countries which, at rstsight, seem more reliable. This sets out a case or activemanagement o bond port olios.

The study is structured as ollows:

Chapter 1 presents a short historical overview, providingreasons or the emergence o the nancial and real estatecrises and explaining the particular signi cance and ne-cessity o scal stimulus during real estate crises.

Chapter 2 explains why private sector and state debts arede erred and what e ect this has on the economy and

nancial markets.

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

Chapter 4 tackles the question o whether debt reductionis possible at all and, i so, under which conditions.

Chapter 5 deals with the problem o an aging populationand its e ects on national debt.

Chapter 6 demonstrates, by using the new Vontobel Fis-cal Risk Index (FRI), which government bonds are seen bythe market as being too negative and there ore are attrac-

tive rom the investors point o view and which are not.

Chapter 7 presents conclusions or the investors.

Dr. Thomas Steinemann,Chie Strategist o the Vontobel Group Dr. Walter Metzler,Senior Economist

Dr. Ral Wiedenmann,Head o Macro Research

March 2010


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Real estate makes up a substantial proportion o per-sonal assets in many countries. It is estimated that inthe USA securities including pension assets make up onaverage roughly 66% o personal assets, yet real estateaccounts or up to 30%. Real estate is typically nancedto a large extent with mortgages, which are o ten stillstate-subsidised. In the USA, owning your own home isstrongly encouraged, and indeed in the mid 1990s theClinton administration actively promoted home owner-ship (see Diagram 1). In the course o rising real estateprices, the banks joined along with a lending policy

which was too lenient: the seeds o the subprime crisishad been sown.

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

loans, which investment banks then began to repackageand resell. But the state also pro ted rom high tax reve-nues. High national debt in many countries in the mid

1990s was able to be reduced substantially right up untilthe outbreak o the nancial crisis in 2007 (see Diagram5). The US Federal Reserves policy o low interest ratesunder Chairman Alan Greenspan nally added uel to the

re even i it was unintentional and urther acceler-ated the hectic activity.

When real estate prices in the USA started to all in 2007the whole process went into reverse. Falling real estateprices orced and continue to orce households to reducedebt and limit consumption. Private individuals mustshrink the size o their balance sheets. Debt reductionand the resultant move away rom consumption led torecession. In this situation, the state only has two pos-sibilities: either do nothing and risk a deep depressionwith unemployment reaching perhaps 30%, or increasegovernment expenditures and in doing so compensate or some o the short all in private consumption and invest-ment. The harsh experience o the 1930s demonstrates,however, that it is entirely correct to choose the secondoption and to accept temporarily increasing de citsand national debt. Nevertheless, the state cannot denya share o the blame or the nancial and debt crises:given the act that many states promoted home owner-ship nanced through debt; and given the de acto state

guarantee o large banks, states do without a doubt bear partial responsibility or the current crisis.

Alongside that o households, part o private debt isthat belonging to companies and nancial institutions.

85 87 89 91 93 95 97 99 01 03 05 07 0963

6465

66

67

68

69

70

Rate of home ownership

Sources: Datastream, Vontobel

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

Thus it is not by chance that in the mid 1990s there arosea large increase in private debt in American households.In Diagram 2 it is possible to see that until the mid 1990sthere were net savings in the private sector (the red barsin positive territory); therea ter, however, there began tobe debts (the red bars in negative territory).

However, the total increase in private debt since 1997 is notexclusively linked to property ownership and thus mort-gages. But the attractive property prices since 1997 (seeDiagram 3) and the Clinton policy were a cocktail which thebanks 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 awin-win situation or everybody: the rising value oreal estate meant that the lending ratio could be in-

creased urther (home equity extraction). This had pos-itive e ects on consumption as well as economic growth.Private households balance sheets were swelling: theassets side through rising real estate values and the liabili-ties side through growing debt. Banks could issue more

10%

8%

6%

4%

2%

0%

-2%

-4%

-6%

-8%

-10%

Private Balance

9 0 9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9 00 01 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9

General government balance Capitol account balance

Sources: Federal Reserve Flow o Funds, Vontobel

Diagram 2: Fiscal balances o the private sector, government andoreign trade must always balance.

USA: sector nancial balances in % o GDP


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Together with national debt these three areas make up acountrys total debt. The total debt o selected countries(as at the end o 2008) was as ollows (see Diagram 4):

It is striking that not all countries which have a high levelo total debt also have a high level o national debt.Spain, South Korea and Switzerland are examples o this.For instance, Spain, which is currently considered to beanother eurozone crisis candidate, has a lower level o na-tional debt than Germany. In contrast, the USA, Canada,Great Britain and Spain have high levels o private house-

hold and corporate debt which must be reduced in thenear uture. Although Switzerland has the highest levelo private household debt (118% o GDP) compared tothe countries analysed, the pressure there to take correc-tive action is less pronounced because the quality o thedebt is higher (high levels o household nancial assets,care ul lending policy, longer periods during which xedinterest rates are locked in). Additionally, in the USA,Great Britain and Spain the commercial real estate sec tor is under pressure. In Spain this is also true or parts o thecommercial sector as well as banks. It is also striking thatall sectors in the major emerging markets like China and

Russia have low levels o debt. Consequently, a distinc-tion between the di erent meanings o the term indebt-edness rom country to country is necessary i conclu-

sions concerning possible state bankruptcy, e ects oneconomic growth or interest rates are to be drawn. Thistopic will be picked up again in Chapter 3 and 6.

0

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108

Financial institutions

Households

Non-nancial Business

Government

% of GDP

300

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100

5080

JP LPI: 6 big Cities NADJ

82 84 86 88 90 92

Japan USA

94 96 98 00 02 04 06 08

US S&P/Case-Shiller home price index10-City Composite NADJ

Source: Datastream, Vontobel

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

Diagram 4: Distribution o debt across our sectors in selec ted countries.

Source: Mc Kinsey Global Institute


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Falling real estate prices and the resultant need to reducedebt have led to the private sector in the USA once againbecoming, or the rst time since the middle o the 1990s,a supplier rather than a consumer o capital to the extento 6% o the GDP (see the red bars in Diagram 2). In turn,the state was more readily able to increase its expenditures,and the de cit reached around 10% o GDP in 2009 (theblue bar in Diagram 2).

Reduced demand or capital rom both the public and pri-vate sectors has made a signi cant contribution to lower in-

terest rates on the capital markets than be ore the nancialcrisis in spite o the level o borrowing by the state. There-

ore, as long as we nd 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 o Japan demonstratesthis clearly. Land prices there have allen continuously over the past 20 years since the bursting o the housing bubble(see Diagram 3), which has meant that companies mustuse their income or ongoing debt reduction. 1 So there wasvery little capital remaining or investment and consump-tion. This was one reason or the prolonged weak eco-

nomic growth in Japan. The e ects o debt reduction led toa sharp increase in the supply o domestic capital, interestrates remained low, and oreign investors nanced only avery small portion o the Japanese debt at 7%.

Studies show 2 that the process o state debt reduction be-gins on average two years a ter the outbreak o a nancialcrisis and lasts or six to eight years. This may possibly belonger or the present crisis. The reason is linked to the actthat, in the past, exports played an important role in eco-nomic growth; as a result o the global dimension o debt with the exception o the emerging countries a simul-taneous expansion o exports is unlikely. The InternationalMonetary Fund (IMF) suggests that the national debts omany 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 scal stimulusto prevent a deep recession, and it can only then set aboutreorganising the state budget. Consequently it would bewrong to aim to reorganise the state budget too early. Thisshould happen only once the private sector is once again ina position to generate enough demand. The phase o pri-vate debt reduction is thus characterised by an increase innational debt. Moreover, it has been shown also in Japan that economic growth is weak during a period o private

debt reduction and only recovers gradually.

Thus we expect that the private debt-reduction process willtake up the next three to ve years. In this phase let uscall it Phase 1 private debt is reduced, yet national debtrises as a result o compensating or lower demand. Eco-

nomic growth is actually positive thanks to scal stimulusbut is clearly below average, and interest rates rise onlyslightly due to the supply o capital. Only a terwards, inPhase 2, should the actual reorganisation o debts startto be taken on. Phase 2 should begin when private debthas returned to a reasonable level and as a prerequisite when asset prices and, most importantly, real estate priceshave stabilised. This is the condition required in order or Japanese circumstances to be prevented. We assumethat the USA will not ollow Japans example because,according to Robert Shiller, who created the well-knownUS home-price index and gave an early warning o the realestate bubble, a ter a 30% correction, US real estate pricescorrespond roughly to their true value.

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

Chapter 2E ects o private debt on the economy and fnancial markets:interest rates remain lower than expected

1 In Japan, in contrast to the USA, it was mostly companies which held debt.2 Mc Kinsey Global Institute, Debt and Deleveraging: The global credit bubble and its economic consequences, January 2010.


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There are no clear scienti c rules to determine how highnational debt may rise. There is a generally acceptedprinciple that economically productive investments suchas roads and schools may be nanced with debt. This isbecause, as a rule, these investments increase growthand in the process more or less nance themselves. Incontrast, expenditures to boost consumer spending suchas public-sector wages, subsidies or the trans er o wealth

or social purposes should be nanced through currenttaxes. This also complies with the principle o airness be-tween generations.

There are multiple reasons or avoiding an excessivelyhigh level o indebtedness. The larger the debt, the higher the risk that the capital markets will demand a higher riskpremium in the orm o interest rates as is happeningcurrently in Greece and other southern European coun-tries. With rising interest rates, the danger o a debt spiralalso increases at the same time because higher interestrate payments infate the de cit. A debt spiral then occurswhen interest rates are higher than the growth o nominalGDP. In order to avoid a debt explosion in this situation, asurplus in the primary budget (the budget excluding inter-

est payments) must be achieved.3

Chapter 3Do national debts even need to be reduced?

Alongside a debt ratio o 60%, the Maastricht Treatystipulates a maximum de cit ratio o 3%. This arises romthe act that the architects o Maastricht took as their starting point growth o nominal GDP o 5% ( or exam-ple, 2.5% real economic growth and 2.5% infation). Atthis potential growth rate, the debt ratio stabilises at 60%i the de cit amounts to 3% on average. I growth is 4%,the de cit can only be 2.3% o GDP in order to keep thedebt at 60%. In the opposite case, growth o 6% would,

or example, permit a de cit o 3.4%. 4

According to a new study by Reinhart and Rogo 5, eco-nomic growth signi cantly worsens starting at a level odebt o 90% o GDP. In 20 industrialised countries in theperiod between 1946 and 2009, no negative infuence ongrowth as a result o low levels o debt was perceivable.With levels o debt o over 90%, however, growth turnedout to be lower by 4 percentage points. Lower growth

urther impedes the reduction o debt. With regard toinfation, there seems to be, interestingly enough, no con-nection between levels o debt and economic growth.

3 See the Appendix or an explanation o the connection between interest rates, primary budget and economic growth.4 Diagram 10 in the Appendix presents all o the combinations o budget de cit and economic growth which can keep national debt constant at 60%.5 C. Reinhart and K. Rogo , Growth in a Time o Debt, Working Paper or AER Papers and Proceedings, 2009.


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Essentially, a high debt ratio can be reduced by highgrowth, restrictive nancial policy, a certain amount oinfation or, in extreme cases, by de aulting. For devel-oped industrialised countries which have not suspendeddebt repayments since World War II, bankruptcy is noviable way o discharging their debts because they wouldbe shut out o the international capital markets or a longtime a terwards.

For similar reasons, hyperinfation as a way out is, in prac-tice, ruled out. Almost all cases o hyperinfation in indus-

trialised countries happened a ter abandoning the goldstandard. Today the capital markets would punish suchattempts with very high risk premiums. Additionally, manycentral banks are independent and are committed to pricestability. In order to substantially increase infation, thecorresponding laws would rst have to be changed (ex-cept in Great Britain where the Chancellor o the Excheq-uer sets the infation target).

A moderate rise in infation appears likely, however, andit also plays a part in reducing the debt ratio. A targetinfation o 2%, as is prescribed by the ECB, is also, with

regard to the debt problem, a sensible value and wouldcontribute to debt reduction. It is possible that temporaryrates o 3% are tolerable. What is certain is that pricestability cannot be treated carelessly. The credibility ocentral banks is a high-value asset but one which can veryquickly be squandered, and without it monetary policywould become undermined and ine ective. For this rea-son, the proposal by the IMF Chie Economist to aim or an infation target o 4% is also counterproductive andshould not be supported.

Accelerated real growth is without doubt the silver bul-let o debt reduction because other economic targetscan also be achieved as a result. The experiences o coun-tries such as the USA in the post-war period, Ireland andnorthern European countries such as Denmark or Swedenin the 1990s demonstrate this. Yet this approach is im-peded because o private debt reduction and the relativelylow expectations o real growth.

Thus, a realistic approach to reducing debt continues tobe ound in austerity measures. The issue here is to createsurpluses in the primary budget and maintain them over along period o time. As can be seen rom Diagram 5, suc-cess ul consolidation e orts require several years, though

they are possible.

Chapter 4Can national debt be reduced at all?

Sources: OECD, Vontobel

Diagram 5: Debt reduction in selected countries.

Fiscal policies such as stopping the expansion o debt or the Maastricht criteria have proven to be help ul. In con-trast to the widely accepted view, substantial cuts on theexpenditures side during periods o consolidation haveactually proven to be particularly e ective because thelong-term growth rate increases. The reason is linked tothe act that a reduction in expenditures permits a de-crease in distorting, growth-hindering taxes. During theperiod between 1960 and 2000 in 22 industrialised coun-tries which had opted or this approach, the long-termgrowth rate increased by 1.5% or every 10% reduction

in the expenditure ratio.

O particular note is the case o Sweden which, along-side other Scandinavian countries, likewise dealt with areal estate crisis at the beginning o the 1990s (see Box)and success ully began to reorganise the state budgeta ter the end o the slump in the real estate market. TheScandinavian countries also managed to simultaneouslyimplement re orms in the labour market which increasedthe participation rate and productivity. Alongside lowexpenditures, economic growth rose as a result, as did taxrevenues.

Australia

19952008

Uk

19821990

Switzerland

20042008

USA

19932000

Sweden

19962008

Canada

19962007

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Debt ratio in % of GDP


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Balance of the primarybudget, cyclically adjusted

in % of GDP

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Public-sector debt(r.h. scale)

Sources:Datastream, Vontobel

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Real GDP (% YoY, right scale)

Debt consolidation

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

General government balance in % of GDP

Strict budget consolidation in 1996 ( ull 4 percent-age points o GDP) leads to an unparalleld collapse ingrowth (4.2% to 1.5%)

Curtailment o tax increases and wealth trans ers, noautomatic adjustements or infation

A terwards the economy recovers quickly (in the con-solidation phase, the economy grows in real terms by2.8% p.a., while the growth o national dept between

1976 and 1995 is only 1.6%)

Huge budget de cits between 1992 and1994 to over-come the banking crisis

From 1994: savings programme, liberalisation o the rightto terminate employees accompanied by active labour market policy > unemployment alls in parallel with deptreduction rom 11.3% in 1994 to 6.2% in 2008

Taxation ratio ell during the consolidation period rom60% o GDP to 54%

Productivity growth increased: between 1996 and 2008it meausured 2.0% p.a. compared with 1.6% between1976 and 1995 (while national dept increased rom26.1% to 84.4%

Success ul debt consolidation a ter a fnancial crisis. Swedens experience 1996 2008


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Finances due to the nancial and economic crises appearsalmost modest in comparison to the risks posed by de-mographic aging. The burden o an aging population maywell only be elt relatively ar o in the uture, but it canbe almost certainly predicted. The demographic burdenwill come about rstly because the active population inEurope will shrink between 2020 and 2050 (see Diagram6 or the Swiss example). This will reduce growth and taxrevenues.

Secondly, expenditures or pensions, health care and nurs-

ing will increase. In the European Economic and MonetaryUnion (EMU) between 2010 and 2060 this increase willconstitute roughly 5% o GDP. Without countermeasures,the demographic burden will cause the level o debt inthe EMU to grow rom around 80% to 420% by 2060.Switzerland can expect to see debt levels increasing romroughly 40% o GDP today to around 120% by 2050,which is lower but still very high. Social wel are institu-tions would see debt rise more than Federation, cantonand commune.

In the USA, the burden o an aging population on publicnances is less pronounced than in Europe because the

entry o young immigrants into the country has a ectedthe age structure in a less negative way. Without imple-menting countermeasures, debt will nevertheless rise to a

ull 100% o GDP between 2010 and 2060. However, it

is important that the e ects o demographics on debt ino countermeasures are taken will only become obviousat some stage in the distant uture and thus should notbecome intermingled with the current debt crisis.

Chapter 5Demographics and its e ects on debt

4000000

3900000

3800000

3700000

3600000

3500000

34000002010 2020 2030 2040

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2 0 0 4

2 0 0 6

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

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

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

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


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This chapter seeks to investigate whether di erent levelso attractiveness can be established in the market or government bonds. To this end, countries undamental

scal situations are assessed by using a proprietary indexwhich we have developed. This index, called the VontobelFiscal Risk Index (FRI), not only assesses countries accord-ing to their level o debt or budget de cits as is o ten thecase; rather, it assesses them according to a total o sevenindicators which are relevant in painting a comprehensivepicture o a countrys scal risk. Therea ter this true

assessment will be compared with the risks priced in bythe market as measured with credit de ault swaps (CDS).In this way, it can be established which governmentbonds have too much risk in their pricing in relation totheir true scal risk. These are attractive bonds or theinvestor. 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 correctlyvalued by the market.

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

The ollowing actors are incorporated into theVontobel FRI. In our opinion they are the relevant

actors or a comprehensive assessment o fscal risk.

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

2. Cyclically adjusted primary budget. The higher thepredicted primary budget de cit, the lower the chanceo a reduction o debt, and vice versa.

3. The ratio o current nominal interest rates to expectednominal GDP growth. The higher the interest rate inrelation to expected nominal economic growth, thegreater the risks o a debt explosion.

4. Current account de cit. The higher the de cit, thehigher the level o capital injections rom abroad andthus the more susceptible the country is to the fight ocapital, and vice versa.

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

6. Have there been previous consolidation successes?The less o ten successes have been achieved in the

past in generating budget surpluses, the lower thechances that they will be achieved this time.

7. Average maturity o national debt. The shorter thematurity o national debt, the more rapidly high inter-est rates will have an impact on interest expense, andvice versa.


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These seven actors will be established or each country(data sources: OECD, IMF, Bloomberg) and providedwith a weighting. 6 In this way, a risk value, we comparewith the marketprices or the risk (CDS Spread), or eachcountry can be calculated (see Diagram 8). Table 1 inthe Appendix also provides a detailed evaluation o eachcountry.

The ollowing results are striking: in reality, Greecepresents a high scal risk (FRI o 5.7), which is surpassedonly by that o Portugal and Japan (FRI o 6.9). What is

certainly very interesting is that the negative assessmento Greece in accordance with the FRI is not only alreadyincorporated in prices, but rather Greece is even evaluatedtoo negatively. This is because the ascending line in Dia-gram 8 shows the area o air valuation. Greece is posi-tioned very ar away rom this line, which suggests that itis an interesting investment opportunity. The same is true,albeit to a lesser extent, or Ireland, Portugal and Sweden(countries in the green area). Countries which we consider to be valued correctly and all o which are positioned near to the air value line (the white area in Diagram 8) include,

120

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2 3 4 5 6 7

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Sweden

Danmark Finland

SwitzerlandAustralien

Netherlands

Vontobel Fiscal Risk Index

C D S S p r e a

d

GermanyUSA

Belgium

UK EMU

ItalySpain

Ireland

Grecce

Portugal

Japan

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

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

or example, Switzerland, Great Britain, Spain and, justbarely, the eurozone countries taken as a whole. In thecase o Germany, the Netherlands, Japan or the USA, incontrast, the CDS spreads are, according to our analysis,too low or the risks which in reality exist (the red area inDiagram 8). Government bonds rom these countries canconsequently be considered less attractive investment op-portunities because they entail more risk than the marketprice suggests. This may be connected with the act thatthese countries (except Japan) all have a AAA rating,which is underestimating and thus distorting the actual

scal risks.

According to this analysis, the market can be seen to betemporarily evaluating some true risks incorrectly sothat there is a possibility or active investment decisions.Government bonds rom Greece, Ireland, Sweden andPortugal appear as attractive purchase opportunities.Market distortions also come about, in our opinion, asa result o ratings agencies, which lead to a distortion omarket prices; the true risks are particularly or the USA,Japan and Germany higher than the CDS spreads suggest.

6 The composition o each countrys FRI can be seen in Table 1 in the Appendix.


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1. Economic growth over the next three to ve years(Phase 1) will remain positive, although clearly belowthe potential growth rate. The reason is that this periodis characterised by the private debt reduction o compa-nies, private households and nancial institutions eachdepending on the country concerned. To compensate or reduced demand, the state is increasing its debt. In a sec-ond phase rom around 2014 onwards the process oreorganising national budgets can be started. This Phase 2could take up to 10 years or more.

Active management is more

sought a ter than ever.

2. Due to deleveraging in the private sector, net capitalwill be o ered in the developed countries. This keepsinterest rates lower than has been widely assumed. Therisks o either a rise in interest rates or infation existpredominantly in the transition period into Phase 2. Thiswould then be the case i demand were to increase again

and the liquidity created had not been absorbed correctlyby the central banks, resulting in the risk o a steep rise ininfation. Earnings on shares are expected to be positive inPhase 1, though lower than the historical average. Bondsare expected to produce lower yields o between 0% and2%, possibly even producing negative earnings in Phase 2.

3. Over the coming years, tectonic shi ts lie in storein the area o debt development, in monetary and scalpolicy, in shi ts in power rom West to East as well as interms o demographic shi ts. For this reason, static in-vestment concepts are not advisable or either private or institutional investors. In act, to recommend otherwisewould almost be tantamount to negligence. Both types oinvestors cannot ail to regularly examine their strategicasset allocations. Even in the eld o tactical investmentpolicy, an increased number o opportunities exist or ac-tive cultivation and management o port olios as shownin the example o the Vontobel Fiscal Risk Index. In viewo the enormous challenges in the coming years, we canno longer assume that the nancial markets will producehigh yields or that it is advisable to simply hold an invest-ment. Staying with the example o the bond markets:does a passive investor really want to buy more bonds incountries that must issue more and more bonds because

they cant keep their own house in order?

Chapter 7Conclusions or the investor


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Interest rate, primary budget and GDP growthIt is o ten asked why the primary budget (the budgetwithout interest payments) is used or evaluating s-

cal policy rather than the entire budget de cit. Becauseinterest payments cannot be changed by scal policy,budgetary reorganisation measures must be set using theprimary budget (the budget without interest payments).

For a balanced primary budget, interest payments corre-spond exactly with the budget de cit. Given a debt ratioo 100% o GDP, an interest rate o 5% produces a de -cit o 5% o GDP. The debt also grows by exactly 5%. IGDP growth is also 5%, the debt ratio there ore does notchange. I , on the other hand, GDP growth is less than

5%, the debt ratio increases.

Nevertheless, i the state wishes to hold the debt ratioconstant, it must create a surplus in the primary budget.I growth only reaches 2% and the interest rate is at 5%,the surplus in the primary budget must be 3% o GDP inorder to keep the debt ratio constant.

Appendix

Debt/GDP2010

Cyclicallyadjusted pri-mary budgetbalance 2010

Annualproductivitygrowth20002010

Interest rate nominal GDPgrowth rate2010/2011

Past largescal

improve-ments*

Currentaccountde cit19982008

Averagematurity odebt

VontobelFiscal RiskIndex

Weightings 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

5.0%4.5%

3.5%

2.5%

1.5%

4.0%

3.0%

2.0%

1.0%

0% 1% 2% 3% 4% 5% 6% 7% 8%

0.5%0.0%

Nominal GDP growth

Maastricht Treaty target

B u

d g e

t d e

c i t

t o G D P r a

t i o

Diagram 10: Budget defcit in % o GDP to achieve a debt ratioo 60% o GDP as a unction o nominal economic growth.

This table shows the Vontobel Fiscal Risk Index and the sub-indices. A higher value means a greater risk. The index ranges rom 0(very low risk) to 10 (very high risk). CDS values are or 15 March 2010.Sources: OECD, IMF, Bloomberg, Vontobel*Cyclically Adjusted Primary Balance according to IMF since 1985.

Source: Vontobel

Table 1: Vontobel Fiscal Risk Index (FRI)


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