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IN THIS ISSUE

1. Overview 2 2. Where is the Aaa-Aa Demarcation Zone? 5 3. Mapping the Near Future – Our Scenarios 7 4. Updates on the Largest Aaa Governments 8

France 8 Germany 10 United Kingdom 12 United States 14 Spain 18

5. Updates on Selected Other Aaa Countries 20 6. Special Focus: Dimensioning Debt Reversibility 24 Appendix: Debt Projections 28 Moody’s Related Research 30

Analyst Contacts LONDON 44.20.772.5454 Pierre Cailleteau 44.20.7772.8735 Team Managing Director [email protected] Arnaud Marès 44.20.7772.5390 Senior Vice President [email protected] Sarah Carlson 44.20.7772.5348 Vice President - Senior Analyst [email protected] Anthony Thomas 44.20.7772.5635 Vice President-Senior Analyst [email protected]

FRANKFURT 49.69.7073.0700 Dietmar Hornung 49.69.7073.0790 Vice President-Senior Analyst [email protected] Alexander Kockerbeck 49.69.7073.0724 Vice President-Senior Credit Officer [email protected]

NEW YORK 1.212.553.1653 Naomi Richman 1.212.553.0014 Senior Vice President [email protected] Kristin Lindow 1.212.553.3896 Senior Vice President [email protected] Steven Hess 1.212.553.4741 Vice President-Senior Credit Officer [email protected]

This third issue of Moody’s Aaa Sovereign Monitor takes stock of the situation of the highest-rated governments as they face an increasingly delicate balancing act. Moody’s concludes that all large Aaa governments have the capacity to rise to the challenges that they face and that their Aaa ratings remain well positioned, although tail risk has widened.

This report examines the challenges facing the four largest Aaa-rated governments - France, Germany, the United Kingdom and the United States - as well as those of Spain and of the much less fiscally-challenged Nordic European countries.

The recovery that has taken hold across the global economy remains comparatively fragile in several of the large advanced economies, most of which have also implemented the most expansionary fiscal and monetary policies. This exposes governments to substantial execution risk in the implementation of their exit strategies, which can make their credit more vulnerable. The challenges facing Aaa governments can be summed up as follows:

» Growth alone will not resolve an increasingly complicated debt equation. Preserving debt affordability at levels consistent with Aaa ratings will invariably require fiscal adjustments of a magnitude that, in some cases, will test social cohesion.

» Tightening fiscal policy before private demand has become self-sustaining would involve the risk of putting growth on an even lower trajectory, thereby damaging a government’s main asset: its power to tax.

» Postponing fiscal consolidation much longer is no less risky as it would test the patience of the market – and of central banks. Although Aaa governments benefit from an unusual degree of balance sheet flexibility, that flexibility is not infinite. At the current elevated debt levels, a rise in the government’s cost of funding can very quickly render debt much less affordable – and potentially exert more abrupt pressure on the ratings.

The ability of the largest Aaa governments to balance these considerations successfully and thereby preserve their credit rating ultimately hinges on the credibility of the long-term fiscal adjustment plans that they will have to implement.

This report also elaborates on the concept of ‘debt reversibility’ (see special focus at the end), which reflects the extent to which a Aaa government can repair its balance sheet after suffering a large shock. This concept is central to our rating deliberations, as we would not downgrade a Aaa government mechanistically if its debt metrics were merely stretched, but only if we concluded that the government was unable and/or unwilling to quickly reverse the deterioration it has incurred.

March 2010

QUARTERLY MONITOR NO. 3 MARCH 2010

http://www.moodys.com/�

mailto:[email protected]�









2 Aaa SOVEREIGN MONITOR MARCH 2010

What to find in this report

This quarterly report sheds light on and puts into practice the conceptual framework Moody’s uses in analyzing debt metrics in order to identify rating pressures on Aaa-rated governments. The report also contains updated data to illustrate debt trajectories under different scenarios.

Section 1 presents an overview of the challenges facing the main Aaa-rated governments.

Section 2 presents our analytical framework and identifies the Aaa-Aa demarcation zone.

Section 3 briefly recapitulates the stylized scenarios that we use to illustrate possible fiscal outcomes.

Section 4 provides an update on the position of the four largest Aaa governments (France, Germany, the United Kingdom and the United States) as well as that of Spain.

Section 5 provides a snapshot of the situation of selected other Aaa governments: this quarter, we focus on the Nordic countries (Denmark, Finland, Norway and Sweden).

Section 6 (Special Focus) explores and dimensions the concept of debt reversibility, which addresses the extent to which we believe that a Aaa government can plausibly repair its balance sheet after a shock.

The Appendix provides data underlying the debt trajectories under stylized scenarios for the countries covered in this issue of the Aaa Sovereign Monitor.

1. Overview

Low-Speed Recovery in Large Aaa Economies

The recovery of the global economy now appears to be more robustly under way, with the IMF expecting world output to expand by almost 4% in 2010 and to accelerate moderately in 2011.

However, the largest Aaa-rated countries are not faring quite as well. The steady growth in the US appears driven more by the turn of the inventory cycle than by personal consumption, which raises questions about the strength and durability of the recovery. Nevertheless, the US economy is performing considerably better than that of its large European Aaa-rated peers. The UK finally emerged from its long recession at the end of 2009, but with weak momentum. The euro area, which had fared better initially, is showing some signs of losing steam. The Spanish economy in particular is not expected to grow at all over the course of 2010.

In several of the Aaa economies, growth is likely to remain constrained over the coming years by the process of de-leveraging and strengthening in their financial sectors – a process actively encouraged by governments and regulators. Demand is also likely to be negatively affected by a higher household savings ratio against a backdrop of weak employment and in the US fragile housing market. Demand from the emerging world undoubtedly provides some support, but cannot on its own compensate for weak domestic demand. Buoyant exports to China and India in late 2009 did not prevent Germany from registering flat GDP growth in the last quarter of the year.

These trends are broadly consistent with our baseline macro scenario of a ‘hook-shaped’ recovery: the recovery is taking place indeed, but at a protracted, muted pace. This is also consistent with historical experience: a McKinsey Global Institute study1

1 “Debt and deleveraging: the global credit bubble and its economic consequences”, McKinsey Global Institute,

January 2010.

shows that in 32 recorded episodes of economic de-leveraging, growth only once played a major role in facilitating de-leveraging (and even this one episode is not applicable to the current circumstances as it refers to the US at the start of the Second World War). It is worth underlining that the considerable ongoing increase in public debt across advanced economies currently is primarily the consequence of a defensive deployment of government balance sheets at the start of a global de-leveraging process.


Heightened Execution Risk for Exit Strategies…

What does this mean for large Aaa governments?

First, it means that that the burden of repairing the damage caused by the financial and economic crisis to their balance sheet falls disproportionately on discretionary fiscal adjustment. Some governments (e.g. the US) will gain comparatively more support from growth, but none can rely much on it.

Second, it means that debt metrics will continue to deteriorate over the near term. Public deficits will remain very large in the largest Aaa countries in 2010, - and in several cases larger than they were in 2009.

Third, it means that downside risks associated with the timing and sequencing of fiscal and monetary exit strategies are substantial:

» Tightening fiscal policy too early, at a time when private demand is not yet self-sustained, would undermine the fragile recovery and possibly undermine the governments’ main asset: their power to tax.

» Maintaining fiscal policy too expansionary for too long, however, is no less risky, if it leads to markets losing patience and confidence, and even more so if a drift in inflation expectations forced central banks to take the initiative first. At the current elevated levels of debt, rising interest rates would quickly compound an already complicated debt equation, with more abrupt rating consequences a possibility.

Fourth, it means that the emphasis of the market – and our own - will move increasingly away from public finance developments in 2010, towards medium-term consolidation plans and the credibility thereof. Anchoring fiscal (and inflation) expectations will be key to preventing the risks associated with a ‘late’ exit from materialising. Germany was the first Aaa government to attempt to anchor fiscal expectations by introducing a ‘debt brake’ in its constitution. France has announced its intention to introduce a binding fiscal rule, although it has not yet provided details. The US administration has announced the establishment of a National Commission on Fiscal Responsibility and Reform.

…But No Imminent Rating Pressure for Aaa Governments

Against this background, the variance of possible outcomes over the medium-term has increased somewhat relative to the situation that prevailed at the time of the December 2009 issue of our Aaa Sovereign Monitor. The governments covered in this report include the four largest Aaas – France, Germany, the United Kingdom and the United Sates – as well as Spain, the first Aaa government to face significant market pressure to announce a credible adjustment plan, and which, in our view, has risen to the challenge. The report also provides shorter updates on the position of the four Nordic European countries (Denmark, Finland, Norway and Sweden).

The stable outlook on the Aaa ratings of the largest governments reflects the observation that the affordability of public debt is deteriorating significantly in all cases (as illustrated by the chart on p.4) but, on current projections, not to a level that would threaten their ratings. The next section provides a detailed reminder of how Moody’s defines the Aaa-Aa boundary for sovereigns.

Moreover, all these governments maintain very high levels of finance-ability, by which we mean that they are still able to raise considerable amounts of debt without experiencing a sharp rise in their cost of funding. A rise in the cost of funding is, however, a possible, even plausible scenario as the recovery gathers pace and central banks discontinue the exceptional measures put in place during the crisis. Sensitivity analyses (provided in the country-specific pages that follow) show that this could quickly raise the debt burden of the large countries, especially those - such as the US - that will need to roll over a large proportion of their debt in coming years.

Should that be the case, the ability of governments to reverse debt dynamics (the concept we label ‘debt reversibility’) will be tested and this ability will have to be demonstrated to continue to provide support for the ratings. As discussed on page 24, we believe that all the large Aaa governments have the capacity to raise to the challenge that they face. Those, for which we


assume a lower debt reversibility, such as France, are also governments that face comparatively lesser challenges. By contrast, the United Kingdom or the United States have stretched debt affordability farther but, in our view, also have higher debt reversibility. On balance, we believe that the ratings of all large Aaa governments remain well positioned - although their ‘distance-to-downgrade’ has in all cases substantially diminished, and tail risk has widened.

Nordic Countries: Déjà Vu - or Something New?

We also provide an update on the situation of the four Nordic countries: Denmark, Finland, Norway and Sweden. As shown in the chart below, they are much less fiscally-challenged than their larger peers and their Aaa ratings are not in question. Nevertheless, all four - being open, small economies - have been impacted by the collapse in world trade that accompanied the economic crisis. They were also affected by the financial crisis given the relatively large size of their banking systems, which led them to implement financial rescue operations. Sweden’s banks have extensive operations in the hard-hit Baltic nations, so the Swedish authorities had to provide another layer of at least implicit support there.

However, the Nordic countries entered the crisis in a much better position than they did when three of them faced their own financial and economic crisis in the early 1990s: their public finances as well as their economies were in substantially better condition this time in terms of lower debt, strong competitiveness and improved diversification. Moreover, the Nordic governments have an established track record of fiscal prudence, which should exempt them from the market skepticism that has plagued other European countries from time to time in recent months. Having had relatively sizeable fiscal surpluses prior to the crisis, the three EU members, Sweden, Finland and Denmark, all have credible ambitions to regain balanced fiscal positions (and not merely a 3% deficit) in their medium-term programs. Norway intends to go back to its fiscal rule of limiting the use of its oil- and gas-related revenues for current spending after having spent a much larger amount of such revenue last year over the same time frame.

Going forward, these countries are benefiting from the upturn in world trade and are in a good position to resume stronger growth than the European or OECD averages – although the global scope of this crisis will prevent a full repeat of the export-driven model, which propelled the Nordics back to economic health in the early 90s. The recovery can also be supported by renewed efforts to expand their labor supplies through extending working lives, bringing young people into the workforce earlier, and reducing access to various work leave schemes, thereby countering demographic pressure.

Debt trajectories 2009-2013 - Baseline scenarios Countries covered by the March 2010 Aaa Sovereign Monitor

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Aaa Space


2. Where is the Aaa-Aa Demarcation Zone? This section summarises our analytical approach to differentiating between Aaa and Aa sovereigns. It provides a guide to interpreting the country-specific ‘debt trajectory charts’, which offer a graphical illustration of a government’s ‘distance-to-downgrade’2

Which factors determine the Aaa-Aa boundary? Moody’s Sovereign rating methodology is based on an assessment of four rating factors: (i) the economic strength of a country, (ii) the robustness of its institutions, (iii) the strength of the government balance sheet and (iv) its vulnerability to event risk. Countries eligible for a Aaa rating score highly on all factors. While the other factors are more stable over time, the main factor that might lead a government to lose its Aaa rating in the current crisis is a deterioration of its balance sheet. Therefore, at the Aaa-Aa boundary, our emphasis is primarily on debt metrics.

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The focus is on affordability, not sustainability: At both the Aaa and Aa level, the risk of default is negligible. The point at which a Aaa government crosses over the Aaa-Aa boundary does not reflect the point at which debt is intolerable, but the point at which debt becomes a material and noticeable constraint in the making of public policy. This is a normative assessment, informed by historical references.

How do we measure the inconvenience of debt? Our primary measure in this context is debt affordability. This is defined as the proportion of a government’s revenues that is consumed by the service of the debt (interest payments to revenue ratio). This indicator captures, much better than debt/GDP for instance, the burden of public debt for a country because it encapsulates not only the size but also the cost of debt. The higher this ratio, the more public debt constrains the formulation and delivery of other policies.

The Aaa category does not have an upper boundary: There is no limit to how creditworthy a government can become. Therefore the ‘altitude’ of a government within the Aaa space matters. Negative economic and financial news and a deterioration of credit metrics need not translate in a rating downgrade, if the initial position of the government is very high within Aaa space to begin with. Such changes may simply result in a loss of altitude – in other words, a narrowing of the government’s ‘distance-to-downgrade’.

Where does the Aaa-Aa boundary lie? Historically, countries with single digit debt affordability ratios do not experience material interference to policy formulation and execution as a consequence of their public debt. When the affordability ratio moves into double-digit territory, policy becomes perceptibly constrained. This 10% threshold marks the Aaa-Aa boundary.

The assessment is not static but dynamic: Moody’s defines a Aaa government as a government whose debt is highly affordable and whose balance sheet flexibility allows it to keep debt highly affordable across cycles and crises. Rating assessments are forward-looking: it is not just whether a government’s debt affordability deteriorates as a consequence of a shock that is important, but whether the government can absorb the shock and repair its balance sheet. Balance sheet flexibility has two components:

» Debt finance-ability which is the ability of the government to raise large amounts of debt without triggering large increases in its cost of funding;

» Debt reversibility which is the capacity of a country/government to restore debt affordability after a shock, by combining discretionary fiscal adjustment and/or nominal growth.

Governments are rated on the same rating scale as corporations or banks, but benefit from a greater degree of balance sheet flexibility than other issuers. This is because they can unilaterally increase their revenues (through taxation) and in some cases influence the amounts that they can borrow and the price at which they do so (through regulation).

2 We encourage readers to refer to Moody’s Special Comment entitled ”Why Aaa Sovereigns get Downgraded”

(September 2009) which provides further details about our approach.

http://v3.moodys.com/viewresearchdoc.aspx?docid=PBC_119194�


How to Interpret our Debt Trajectory Charts

We illustrate the evolution of a government’s “distance-to-downgrade” in the form of debt trajectory charts similar to the one shown below. These charts plot the position of a government, year-by-year, on the basis of their debt/GDP ratio and debt affordability ratio.

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What do the axes represent? The horizontal axis of the chart measures simply the debt/GDP ratio. The vertical axis measures the debt affordability ratio, which is the more relevant concept for determining a government’s “distance-to-downgrade”. This axis is inverted, so that a downward trajectory over time means a deterioration of debt affordability, i.e. a loss of altitude in the rating space.

How to identify rating pressure points from the chart (Aaa Space and Aa Space)? The space of the chart consistent with a single digit debt affordability ratio (i.e. the space above the shaded band) is labeled the “Aaa space”. A Aaa government, whose debt is projected to remain in this range under plausible scenarios would face no particular rating pressure. The space of the chart below the shaded area is labeled Aa space. If a debt trajectory enters this area, the likelihood is that a government would not be able to bring its affordability ratio back to a level consistent with a Aaa rating for a prolonged period. This is the situation that led to the downgrade of Ireland from Aaa to Aa in July 2009.

How does debt finance-ability appear on the chart? The slope and curvature of the curve provide a crude indication of a government’s degree of debt finance-ability. A flat curve indicates that a government can increase its debt without experiencing a dramatic deterioration of its debt burden. A steeper curve indicates that a rise in debt is accompanied by a rapid deterioration of affordability – typically through an associated increase in interest rates (which makes the curve bend). Interest rates may of course be influenced by factors other than government borrowing.

What is the debt reversibility band and how to interpret it? The shaded area is labeled “debt reversibility band”. This shows how far debt affordability may potentially deteriorate without necessarily threatening the Aaa rating of a government. A debt trajectory that enters the reversibility band means that the adjustment capacity of the country is being tested. The maintenance of the Aaa rating becomes conditional on a government making use of its adjustment capacity to repair the damage.

The width of the band is country–specific (see section 6 on p24). If a government’s debt affordability ratio rises to 13% during this crisis, but we believe that it can realistically and rapidly bring the ratio back to single digit levels, the width of the band would be 13% - 10% = 3%. A lower adjustment capacity would translate into a narrower reversibility band.


3. Mapping the Near Future – Our Scenarios Moodys’ ratings are determined by looking at how government debt metrics perform not just under one scenario, but under a wide range of plausible states of the world. There are numerous variables that can affect trends in debt affordability for Aaa governments over the next few years.

The first is the eventual impact of the financial sector rescue operations on the government’s debt. This remains uncertain despite the reduction in government exposure as banks exit government support schemes. The final cost of these operations depends on the value at which assets acquired (such as equity in banks) will be realized and on whether any guarantee issued will end up being called.

Other variables that will affect affordability are the trend in interest rates, the pace of economic recovery and of course the magnitude of the fiscal consolidation efforts that governments will undertake.

In order to capture plausible outcomes and risks around these scenarios, we have developed two main scenarios and several variants. The assumptions underlying the two main scenarios are described in the table below. These scenarios are illustrated graphically in the main debt trajectory charts for each country.

TABLE 1.

Main scenarios

Economic assumptions Financial Sector Rescue Operations Recovery assumptions

Baseline scenario (blue line)

» Muted economic recovery » Moderate fiscal adjustment (generally

in line with government plans) » Moderate interest rate shock3

» Financial Sector Rescue operations add to net debt, with recovery rates on residual exposure close to historical experience (55% on fiscal measures). Recovery time of 5 years.

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Adverse scenario (orange line)

» Lower rate of growth (by 0.5% each year);

» Lower fiscal adjustment (primary balance lower by 1% of GDP each year);

» Stronger interest rate shock.

» More severe recovery assumptions: 30% on fiscal measures. Recovery time of 10 years.

In addition, for the four largest Aaa governments and Spain, we graphically represent variants of the baseline scenario to illustrate the sensitivity of debt affordability to the level of interest rates, to the trend in growth and to the magnitude of the fiscal adjustment (in each case, all other factors remaining equal). This includes extreme scenarios, the plausibility of which is admittedly low, but which are useful for identifying vulnerabilities. The assumptions underlying these scenarios are summarized in the table below:

TABLE 2.

Assumptions for sensitivity analysis

Uplift/Discount applied

Nominal Growth Sensitivity

Fiscal Adjustment Sensitivity Interest Rate Sensitivity

2010 2011

onwards 2010 2011

onwards 2010 2011

onwards

VF Very Favorable +1%p +2%p -1%p -2%p - -

F Favorable +0.5%p +1%p -0.5%p -1%p -50bps -100bps

S Severe -0.5%p -1%p +0.5%p +1%p +100bps +200bps

VS Very Severe -1%p -1%p +1%p +2%p +150bps +300bps

3 For interest rates, we assume in the baseline scenario that the average borrowing costs of governments in 2010 will

be 75 bps above the current 3-month moving average of the 5-year government bond yield. We then assume a further 100 bps increase in yields in 2011, and 25 bps in 2012. For the adverse scenario, we assume interest rate shocks to be twice as large as in the baseline scenario for each year.


4. Updates on the Largest Aaa Governments

France The French economy is continuing to perform relatively better than many of its peers. GDP contracted by 2.2% in 2009. While this was the deepest recession France has experienced in the post-war era, it remained shallow relative to that experienced by its peers, and milder than initially expected. This benign performance is essentially attributable to the remarkable resilience of household consumption (French households entered the crisis with comparatively low levels of debt and no pressing need to de-leverage their balance sheets) and to the extensive effects of automatic stabilizers. The former is expected to continue to provide support to a recovery that appears, on the whole, to be better anchored than in other large European countries, with GDP increasing by 0.6% in the fourth quarter of 2009. The government objective of 1.4% real growth (revised up from 0.75%) in 2010 is not out of reach.

Recovery in Tax Receipts is Marginally Improving Debt Trajectory

As a result of better-than-expected economic performance, the government’s tax receipts have also performed better than expected, leading to a marginal downward revision of the public deficits for 2009 (from 8.2% of GDP to 7.9%), and 2010 (from 8.5% of GDP to 8.2% - a higher level than in 2009 owing to the lagging effect of the recession on unemployment and therefore on social expenditure).

The magnitude of the public deficits reflects the fact that if the economic effect of the crisis was cushioned, it is because the government has absorbed a substantial part of it on its own balance sheet. The rise in public debt has been considerable: from 64% of GDP pre-crisis to a projected peak in the neighbourhood of 90% of GDP over the next three or four years according to the government’s own projections.

The French government’s Aaa rating is not in danger over the near-term because, as illustrated in the charts on the following page, debt affordability is projected to remain well within the range consistent with a top rating under most plausible scenarios. The benchmark status of French government bonds (along with and second to German Bunds) in the euro market also contributes to a very high degree of finance-ability. The yields at issuance of French government bonds currently remain below the medium-term nominal growth potential of the economy.

Stability Programme Vulnerable to Growth Outlook

Still, the ongoing deterioration of public finances does result in an inexorable erosion of the French government’s “distance-to-downgrade” because the ability of the government to restore the fiscal shock-absorption capacity that was lost during the crisis remains doubtful. The stability programme presented by the French government at the end of January confirms a reliance on growth as a means of bringing the deficit back to 3% of GDP by 2013. This is best illustrated by the government’s indication that, in the event of medium-term growth being lower than its assumption of 2.5% per annum, the deficit reduction would be more gradual, and the target of 3% of GDP for the deficit would only be reached in 2014. While this emphasis on growth is a legitimate policy choice, it also highlights two weaknesses of French public finances that complicate the adjustment process: the high level of tax pressure, which does not facilitate raising additional revenues, and the rigidities of expenditure. The assumption underlying the government’s adjustment programme is that central government’s real expenditure will remain constant on average over the next four years, while social security expenditure continues to increase, thereby raising the projected real growth of general government spending to just under 1% per annum. This does not appear a particularly ambitious objective, and yet it is likely to prove challenging in view of unsuccessful efforts to bring expenditure under control in the past.


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Distance to Downgrade – Main Scenarios

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Germany

Favourable Initial Position Allows Absorption of Effects of Crisis Without Unduly Stretching Debt Affordability

Due to the challenges of German unification the economy and fiscal authorities had already implemented a large-scale adjustment in the mid-1990s. As a result, the German economy today seems better placed to recover momentum than many other EU countries whose economies are seriously impaired by high private indebtedness and the collapse of over-inflated financial and construction sectors. For those countries the tailwinds of the past have transformed into heavy headwinds. Thanks to the lack of debt-driven distortions in Germany’s domestic economy, there is a much lower need for growth-dampening deleveraging through a (private) debt reduction. However, the need to repair banks’ balance sheets remains a potential hurdle obstructing a more dynamic recovery.

With rising public debt and only moderate economic growth prospects over the coming years, Germany’s debt affordability will be tested – as it will be in many other countries. We expect Germany’s public debt burden to continue to compare favourably with the country’s payments capacity, as indicated by the debt-to-revenue and interest-to-revenue ratios. Moreover, the benchmark status of German government debt is helping to keep debt affordability at relatively high levels even in scenarios of further rising public debt.

In fact, as in many other countries around the world, the cost of adjusting to the global crisis will be high, with a large portion of the burden to be absorbed by the public sector. Germany’s government debt is projected to rise significantly, approaching 80% of GDP by 2011 on the back of new borrowing, only moderate economic growth and costly financial and economic stabilisation measures.

“Debt Brake” Aims to Anchor Fiscal Expectations Despite Near Term Deterioration

The coalition programme of the new Christian-Liberal government appears to further prioritise economic support measures over fiscal consolidation – at least temporarily – in the hope of underpinning the economic recovery. It contains further stimulus measures to provide (tax) relief to households and enterprises and to increase public infrastructure investment. At the same time, automatic stabilisers are being allowed to operate fully. As a result, the general government balance has turned into a deficit of close to 3% of nominal GDP in 2009. The deficit ratio is projected to increase to around 5% of GDP in 2010 and 2011, thereby further adding to a rising public debt ratio.

General government debt in relation to nominal GDP was around 66% in 2008 and its debt affordability ratio stood at 6.3% at that time. Our scenarios point to some erosion of the debt affordability ratio over the next two to three years, but it is projected to remain substantially below double-digit levels.

However, like other highly rated sovereigns, Germany will not be able to rely on robust growth to help reverse the debt trajectory. Fiscal adjustment capacity, especially through expenditure control, will be of increasing importance. In this respect, the recent decision to introduce a public "debt brake" to limit the structural deficit at all levels of government is a supportive factor in terms of debt reversibility, provided the rules are respected. The new fiscal rule is anchored in the German constitution and stipulates a ceiling of 0.35% of GDP for the structural deficit of the federal government as of 2016. The German Länder will be forced to present balanced structural budgets as of 2020. These rules require substantial fiscal consolidation from 2011 onwards. The government’s ability to adhere to the rules will be tested, especially if tax and other support measures do not result in the targeted economic recovery. This also means that the government’s capacity and willingness to better control expenditure – especially in view of increasing pension liabilities – will be further tested.


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United Kingdom

Slow Recovery Casts Doubts over Trend in Tax Revenues, Exerting Pressure on Debt Affordability

The UK economy has officially emerged from its long recession, but only just: the revised estimate for GDP showed a 0.3% rise in the last quarter of 2009, after six consecutive quarters of contraction. While survey data pointed to an earlier recovery, the fact remains that the UK economy continues to face significant headwinds and the recovery is still fragile. The UK entered the crisis with a very high level of leverage (total private and public debt as a percentage of GDP) and the effects of de-leveraging are therefore likely to be felt more deeply, but also for longer than in many other economies. Given the adjustment that has already taken place, in particular to household savings, and the more supportive international environment, the risk of a double-dip recession seems low, although the risk remains that growth continues to be modest for some extended time.

A muted pace of recovery creates downward risk for debt affordability. The risk is that tax receipts recover more slowly and less fully than initially envisaged. This would accelerate the ongoing deterioration of government debt affordability as captured by the ratio of the cost of servicing the debt to government revenue. The relatively low level of public debt at the start of the crisis (44% of GDP for gross debt) created fiscal space and allowed the government to counter the rise in private savings in the form of very large public deficits. This fiscal space is currently being used to the full and public debt is rising rapidly. Under current government projections, it is projected to stabilise at around 90% of GDP in the coming years. The risk, if tax receipts fail to recover quickly enough, is that debt rises even further.

As the level of debt rises, affordability becomes increasingly sensitive to the government’s cost of funding. So far, HM Government has benefited from favourable market conditions, with the UK Debt Management Office generally issuing long-term debt at yields that have remained below the long-term nominal growth potential of the UK economy. The extent to which the purchase of £198 billion of gilts by the Bank of England in the context of its quantitative easing policy (£4 billion in excess of the total amount of gross gilt sales by the UK Debt Management Office over the same period) has distorted prices in favour of the government is debatable. If the initial IMF estimate of 40-100 bps is broadly accurate, however, the discontinuation of these purchases, announced by the central bank on 4 February, creates upside risk to yields. At a minimum, it exposes the government more directly to market scrutiny. The chart on the top right of the following page illustrates how a rise in gilt yields may – despite the long average life to maturity of public debt in the UK - quickly stretch debt affordability to a level that, if it were maintained over time, would not be consistent with a Aaa rating.

Fiscal Margins Suggest Sufficient Capacity for Adjustment Still Exists

Against a background of stretched debt affordability, the Aaa rating of the government therefore relies on an assessment of high debt reversibility, i.e. a strong ability on the part of the government to restore its debt to more affordable levels through resolute action. The question here is less when fiscal retrenchment ought to start, but rather how credible it is that sufficient retrenchment will eventually take place. A loss of confidence in eventual fiscal tightening by markets (causing yields to rise) or by consumers (resulting in rising precautionary savings) could each complicate the adjustment. Current government projections assume a fall in total managed expenditure from 48% of GDP to around 43% of GDP over the next five years. They also assume a gradual rise in the tax-revenue-to-GDP ratio from approximately 33% to 35.3%. Moody’s believes that there are margins on both sides to generate additional budget resources if required. Such additional efforts would not be out of line with historical precedents and would be politically feasible, in a context where the public support to fiscal consolidation remains strong in our view.


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United States

GDP Growth: One Quarter of Strength, But…?

Real GDP increased at a relatively strong annual rate of 5.9% in the fourth quarter of last year, following a rate of 2.2% in the third quarter. However, well over half of the rise in Q4 was the result of inventory accumulation, and personal consumption expenditures rose only 1.7%, a deceleration from the 2.8% rise in the previous quarter. The household savings rate for the year as a whole was 4.3%, more than double the rate of 2007 - as deleveraging affected spending patterns. Another factor that prevented consumption from growing more strongly is the unemployment rate, which averaged 10% during the last quarter before falling to 9.7% in January and February.

The pattern of growth and the high rate of unemployment raise the question of how strong the recovery will be going forward. The federal government budget assumes a 2.7% real growth rate in 2010, with private forecasts slightly higher. This figure is less than the average growth rate during the ten years up until 2007, which included a mild recession following the bursting of the “high-tech bubble.” During the same ten years, personal consumption rose at an average annual rate of 3.6%, and it appears unlikely to match that rate in the near term. Ultimately, the ability of the US economy to grow more rapidly and, therefore, for government revenues to contribute to fiscal consolidation, will have to depend on a revival in the growth rate of consumption. The need for fiscal consolidation, a poor (but stabilizing) housing market, and low capacity utilization that affects the level of business fixed investment all indicate that other areas of the economy are unlikely to provide strong growth impetus.

Very High Deficit in the Current Fiscal Year

In the budget announced in February for fiscal year 2011, the administration estimates that the federal deficit in the current fiscal year will rise to 10.6% of GDP, the highest level since 1946. For the second consecutive year, total revenues are estimated at 14.8% of GDP, down from 18.5% in 2007 and a recent peak of 20.6% in 2000. The 2009-2010 level of receipts as a proportion of the economy is the lowest since 1950. While this revenue drop shows the severe effects of the recession (and tax reductions that formed part of the stimulus package) on the government’s fiscal position, the exceptionally low level of revenue also indicates that there is room for increasing revenues once the effects of the recession recede.

Expenditures also are setting post World-War-II records, with the current year showing a peak of 25.4% of GDP and FY 2011 only slightly lower. The high levels of expenditure in these two years represent stimulus spending as well as peak spending for defense, although the latter is lower as a percentage of GDP than during the decades from 1950 to 1990.

The very high deficit in the current fiscal year will bring federal government debt to 64% of GDP, according to the budget estimates, compared with 40% two years earlier. Because of the drop in revenue, the ratio of debt to revenue will reach 430%, more than double its level at the end of FY 2007. Nonetheless, for the time being the affordability of the much larger debt has not deteriorated, with the ratio of interest payments to revenue falling to 8.7% in the current year from a recent peak of 10.0% in FY 2008. During the period through 2013, this ratio should rise but remain well below levels reached during the 1980s, according to the budget.

At the general government level (including state and local governments), a measure used for international comparison purposes, the level of debt in relation to GDP will rise to 92% at the end of the current year before reaching 101% by 2013. While this is a very high level, the affordability of the debt, with interest/revenue at 10% in 2013, will just breach the bottom of the reversibility band (as illustrated on the top left chart on page 16). Nonetheless, both federal and general government affordability is growing more vulnerable to any shift in market confidence that would lead to higher interest rates than assumed in these projections.


Uncertain Prospects for Further Fiscal Consolidation

The ten-year outlook included in the budget for the federal government shows a continuous rise in the ratios of debt to GDP and interest to revenue (despite some decline in the ratio of debt to revenue). By the end of the period, debt affordability would deteriorate to approximately the peak level seen during the 1980s, i.e., a ratio of interest to revenue of about 18%. The difference this time, however, is that the ratio would reach that level due to the size of the debt, whereas during the 1980s it was monetary policy that caused interest rates to be high. As monetary policy was eased, affordability improved.

If such a trajectory were to materialize, there would at some point be downward pressure on the Aaa rating of the federal government. The administration has announced the establishment of a National Commission on Fiscal Responsibility and Reform, which is charged with making recommendations for improving the debt trajectory by achieving a primary balance by 2015 (currently projected as a deficit of 0.9% of GDP), as well as other, longer-term reforms. The latter would most likely have to include entitlement programs to be successful. The politics of actually implementing such reforms remain uncertain.

In the charts on the next two pages, we illustrate debt trajectories for both the US general government (the relevant aggregate for international comparison and for an assessment of the degree of ‘constraint’ that public debt exerts on the economy) and the federal government alone (in recognition of the larger degree of separation of federal and local governments in the US than in peer Aaa countries).


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Spain

Spain’s Use of its Fiscal Space to Support Activity Has Not Put its Aaa Rating Into Question

Spain’s debt affordability has already deteriorated significantly and is expected to deteriorate further, taking it close to the Aaa/Aa demarcation line, which would prompt us to reassess its rating. The deterioration reflects the fact that although the government’s debt metrics were sound when the country entered the global financial crisis, it used much of the fiscal space it had created prior to the crisis to run large budget deficits in order to support economic activity in the downturn. Although we see debt affordability getting close to the demarcation line, we do not see it breaking through on most plausible projections.

Debt Financeability Has Not Been Challenged Despite Speculation to the Contrary

Spain has been regularly referred to by financial market commentators as a country that could be affected by contagion should Greece face difficulties meeting its obligations – despite the fact the fundamentals are different in the two countries. In point of fact, this speculation over Spain’s potential vulnerability has not crossed over into market practice. Indeed, the government recently faced no difficulty in raising finance from the market and we do not envisage it facing any such difficulties going forward.

Spain’s “Exit Strategy” is Already Taking Clear Shape

One of the key supports to Spain’s Aaa rating is that although it is currently running large budget deficits and the government’s debt metrics are consequently deteriorating, the authorities’ plans to reduce the deficit and repair the adverse debt trajectory are already reasonably well formulated as a result of this year’s budget, the Action Plan announced in January and the Stability Programme update published in February.

The government is committed to reducing the deficit to 3% of GDP by 2013, from 11.4% last year. In order to achieve this it will need to engineer a fiscal adjustment of 9½% of GDP given the increase in interest payments as a result of higher debt levels. Of this around 5½ percentage points should be delivered more or less in full: the 2010 budget measures, the additional Action Plan measures for 2010, the phasing out of temporary stimulus measures and the cuts to capital spending (though the last two will be implemented primarily in 2011-2013).

Some of the other measures that have already been identified but not yet implemented or formally agreed could be questioned. The cyclical contribution (1½% of GDP), for example, may be less than expected as it is based on growth forecasts of 2½% on average from 2011-2013, which may prove to be too optimistic. The cuts in personnel and administrative costs may also be less as they are based on an assumption that only one in ten public servants will be replaced if they leave the public sector. The targeted contribution to fiscal adjustment from the autonomous regions and municipal governments cannot be guaranteed, but equally they will not want to be seen as profligate in the current environment. Finally, the government has yet to specify a further 1½% of cuts from the central government, though they are expected to do so within the next few months. The government has indicated they will be targeting discretionary spending.

However, even if we assume these latter measures only deliver half the fiscal adjustment the government envisages, the government is already on course to deliver an adjustment of about 7½% of GDP or 80% of the total planned fiscal adjustment. That leaves another two percentage points of GDP if the deficit is to be brought to 3% of GDP by 2013. Given the cross-party commitment to fiscal consolidation, which is widely supported by the population at large, we do not consider this to be an insuperable obstacle for the government to overcome. Equally, given that the deficit will be on a clear downward trend, we would not be overly concerned by, say, a year’s delay in reducing it below the Stability and Growth Pact threshold.


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5. Updates on Selected Other Aaa Countries

Denmark and Finland

Recent and Forthcoming Developments

Debt Growth Fiscal Consolidation Denmark Denmark’s government balance sheet remains

strong relative to most other advanced industrial countries, reflecting low debt prior to the crisis and large accumulated pension savings. However, after the fiscal position moved into deficit in 2009 because of an ongoing contraction of the economy, banking system support and fiscal stimulus, (including automatic stabilizers and tax cuts that will continue into this year) the medium-term outlook has deteriorated substantially. The government’s new EU convergence programme projects that general government debt will rise steadily in the next three years. Debt is now forecast to peak well above 40% of GDP in 2012 compared to a realistic pre-crisis forecast of 25% of GDP. The debt metrics are expected to slowly improve thereafter as the deficit is eliminated again by 2015, likely limited by the pace of growth in Denmark and elsewhere. The increase in the government’s borrowing requirements has induced significant changes in its debt management and issuance strategy. Foreign currency-denominated debt issuance resumed in late 2008, the Treasury bill programme was restarted, and issuance of Danish kroner-denominated bonds was expanded to include 2-, 5- and 30-year maturities instead of only 10-year benchmarks. Debt affordability is expected to remain favorable partly thanks to this active debt management, given the long average duration of the debt, as well as the relatively high revenue ratio.

The Danish economy should return to positive growth in 2010, following a 2½-year recession that was exacerbated by the coincidence of the global crisis and the end of a long and vigorous property boom. The recovery this year is tied to an expected improvement in export prospects as well as a moderate revival in domestic demand, with rising real disposable incomes offsetting the impact of higher unemployment. Similar to most advanced countries, however, the Danish economy is not expected to post growth beyond its potential for the foreseeable future. The relatively weak prospects for the construction sector and investment generally are important factors. The main reasons behind such dour expectations are first, the expected upward trend in interest rates, and second, weaker demand from the country’s trading partners than was the case prior to the crisis. The Danish banking and mortgage financing systems also have been challenged, although the active intervention of the central bank and government, including 100% government guarantees on all bank debt and substantial capital injections, alleviated considerable uncertainty.

Even though the government has undertaken substantial fiscal stimulus and bank support measures in the past two years, the debt/GDP ratio is expected to rise ‘only’ by about ten percentage points to about 42% of GDP at the end of 2010, about half of the Eurozone average. Still, the general government balance moved from sizeable primary surpluses in the previous 17 years to a deficit last year, with additional fiscal measures such as personal income tax cuts expected to lead to an even larger deficit of 5.5% of GDP this year. Nonetheless, successive Danish governments have had a solid track record of fiscal consolidation, and the convergence program for 2010-2015 makes clear that the necessary adjustments in spending will be taken to return the primary balance to a modest surplus by 2013. This would translate into a –deficit of less than 3% of GDP by 2013 and rough balance by 2015.

Finland Finland entered the global crisis from a strong position: in 2008 general government debt to GDP was at 33.6%, and general government interest payment to revenue stood at 2.8% – the third lowest level in EMU after those of Luxembourg and Slovenia. Still, the deterioration in the general government budget balance with the global crisis has been dramatic, as the primary balance deteriorated from +5.9% to GDP in 2008 to -0.8% in 2009. This vicious turnaround has been driven by an approach to let the “automatic stabilizers” work (corporate income tax in particular suffered in the downturn) plus a combination of tax cuts and fiscal stimulus measures. The Ministry of Finance expects that general government debt to GDP will increase to 60.1% in 2015. Contrary to other countries with significant increases in their debt stocks, in the case of Finland bank support measures did not contribute to the rise in debt.

Finland as a small open economy (exports represent 47.0% of GDP in 2008) has been hard hit by the global downturn. Exports are concentrated in metal engineering, electronics and forestry sectors which combined make up for 70% of Finnish exports. This specialization propelled economic growth in the global economic boom and exacerbated the downturn during the global economic crisis. In the first half of 2009, Finnish exports recorded the largest fall of any EMU country. Although consumer confidence points towards a recovery in private consumption, so far higher disposable incomes due to considerable wage growth, low inflation and tax cuts went predominantly into precautionary savings. Moreover, rising job uncertainty and the forthcoming increase in VAT (by one percentage point from 22% to 23% by July 2010) are expected to weigh on future domestic demand. Hence, a meaningful upturn is expected to depend eventually on a surge in global demand.

Substantial adjustments in government spending and tax rates even if GDP growth returns to the potential growth rate are inevitable. The need for adjustment is larger if the recession has long-lasting impact on labor supply. A coherent plan for substantial fiscal consolidation and a medium-term consolidation strategy are still missing though. From today’s point of view, it cannot be excluded that the deadlock on the reform front will endure until the 2011 elections. In the medium to long term, the Finnish authorities aim at moving the tax burden from labor to environmental and consumption taxes. A working group for tax structure is expected to present first results in spring 2010. The most pressing structural issues are a further reform of the pension system (increase in the retirement age) and a reform of local government public finances. Public expenditures at the local level are notoriously pro-cyclical as they are purely revenue-driven. That being said, about two thirds of public investment is made by municipalities.


Debt trajectories 2007-2013 - Denmark

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Norway and Sweden

Recent and Forthcoming Developments

Debt Growth Fiscal Consolidation Norway The Norwegian state has a large net asset

position and could repay its debt with its oil money if it so wished. However, doing so would breach its fiscal rule; this mandates that the budget surplus that is generated from the state’s oil income be invested abroad. Norway also issues debt in order to set a risk-free yield curve and offer investors a risk-free investment alternative. Norway’s government debt has increased due to the financial crisis because of government moves to ease banks’ funding operations. This bond swap programme allowed banks to obtain government securities in exchange for covered bonds. This programme was phased out in December 2009; out of the authorised NOK350bn, banks utilised NOK 230bn of this facility. Note that the debt trajectories in the charts on the opposite page do not include the increase in debt resulting from the bond swap programme.

There is significant uncertainty around Norway’s growth prospects in 2010, which in part reflects uncertainty about the European and global growth outlook, but is driven by domestic factors as well. Norwegian GDP growth turned positive again in Q2 2009, but the recovery failed to accelerate in Q4. Growth was unexpectedly slow, with inventories and public spending acting as a drag on the economy. Private consumption has been an engine of growth in the nascent recovery, but its ability to retain this role may be dampened as future interest rate increases will boost households’ interest expenditures and therefore reduce their capacity to consume (around 90% of Norwegian mortgages are on variable rates).

According to the current fiscal rule that dates from 2001, the use of current oil revenues is limited to an amount equivalent to the estimated 4% real return on the assets of the Government Pension Fund—Global (GPF—G), Norway’s sovereign wealth fund. However, the government is overspending relative to the rule, as it has done in all but two years since the rule was adopted. These deviations conformed with the letter, if not perhaps the spirit of the rule, since they occurred when the economy was judged to be growing below potential. Tapping the revenue that would otherwise be transferred into the GPF—G does not impair Norway’s credit quality in the immediate future. However, continuing to overspend the country’s hydrocarbons income will effectively reduce Norwegians’ long-term standard of living, and potentially distort incentives to develop the non-oil sectors of the economy.

Sweden During the crisis, the government showed its willingness to let the automatic fiscal stabilizers work and to fight the impact of the global economic slowdown on the labor market. With the 2010 budget, the government also proposed measures to encourage more business start-ups and business growth while defending core welfare activities and protecting the climate. Against the backdrop of the crisis, the primary balance to GDP (which posted a surplus of 4.2% of GDP in 2008) turned negative, and is expected to peak at -2.2% of GDP in 2010. The increase in net lending led to a considerable rise in general government debt to GDP, which the Ministry of Finance expects will grow from 38.0% in 2008 to a peak of 45.6% in 2011. Due to favourable refinancing conditions, however, the interest-payment-to-revenue – as a measure for a country’s debt affordability – is expected to remain rather low, not exceeding 3% according to the Ministry of Finance.

Sweden has been particularly exposed to the global economic crisis due to its export-led growth model. Now, economic activity is expanding again, supported by expansionary fiscal and monetary policies, including tax cuts and low interest rates. Apart from the recovery in private consumption, economic growth is spurred by higher exports due to the recent pick-up in global demand. Household sentiment is also improving, which translates into consumption increases, despite a still relatively weak increase in incomes. However, investment is expected to remain a drag on overall economic activity in 2010. The overall improving trend in the domestic economy is set to be reflected in an eventual stabilization of the labour market. Unemployment is expected to peak at around 10% in 2010 – at a lower level than earlier forecasts suggested. In 2011 employment will rise again.

In the 2009 update of the Convergence Programme, the government assesses that the current fiscal course is set to miss Sweden's surplus target. This rule demands that the general government net lending is at an average of 1% of GDP over the business cycle. The next government – parliamentary elections are scheduled for September 2010 – will have to opt for a more restrained fiscal stance in coming years in order to bring the deficit back in line with the surplus target. It is important that measures that are meant to affect public finances only temporarily do not lead to a permanent impact on taxation and expenditure. Still, the overall long-term fiscal perspectives appear relatively good. That being said, this assessment hinges on the assumption that the current deficit of the general government is temporary, and that an austere fiscal stance will be adopted as soon as economic activity improves. Moreover, in the medium to long term, policies that focus on increasing the labour supply and employment would help to improve the course of public finances.


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6. Special Focus: Dimensioning Debt Reversibility As debt affordability is being eroded across the group of Aaa-rated governments - in some cases to the limits of what we would consider consistent, over time, with a Aaa rating - we deem it useful to explain how we define and calibrate the concept of debt reversibility. This follows up on the chapter published in the September 2009 issue of our Aaa Sovereign Monitor, in which we described the dimensions that contribute to debt reversibility (the ability to ‘grow out of debt’ and the ability to adjust revenue and expenditure). In the following pages, we dimension the plausible efforts in the current circumstances.

By debt reversibility, we mean the extent to which a government is able – if willing - to repair its balance sheet and restore debt affordability after a shock. This is the amount by which the ratio of interest payments to the revenues of the government can realistically decrease over a foreseeable time-horizon (5-7 years).

This concept is fundamental to rating decisions at the Aaa-Aa boundary, because we would not mechanically downgrade a government once its debt service payments exceed one tenth of its revenues. We would only do so if we came to the conclusion that either the government was unable to restore affordability to a level consistent with a Aaa rating (the circumstances that led to Ireland’s downgrade in July 2009) or that the government chose to live with a permanently higher debt burden. Debt reversibility therefore provides a measure of the extent to which we would give a government the benefit of the doubt, if its finances were stretched but we believed its determination to correct the situation was unequivocal.

The relevant concept here is therefore the plausible adjustment that a country and government are capable of. It is the size of the adjustment that we assume can realistically be achieved.

There are essentially two ways in which governments can improve the affordability of their debt:

» The first is straightforward fiscal adjustment, in the form of an increase in tax pressure or expenditure cuts.

» The second is to ‘grow out of their debt’, which is the case if nominal growth boosts government revenues at a faster rate than the natural increase in interest payments. This can include any combination of real growth, inflation, and falling interest rates.

We consider both in turn. Given the magnitude of the current fiscal challenge, governments would ideally need both. In practice, growth is unlikely to provide much buoyancy to debt affordability for years to come, and in many cases a lack of growth will in fact complicate the fiscal adjustment and therefore contribute negatively to debt reversibility.

Fiscal Adjustment Capacity: Dimensioning the Plausible Effort

Politically Feasible Primary Balance

The magnitude of the fiscal adjustment that a government can plausibly undertake can be captured by estimating the maximum primary surplus that it can deliver. This is bounded by:

» a country’s tolerance for taxation; And

» the minimum amount of government expenditure (public services) that citizens will demand and that they are in a position to impose, because they will vote into power politicians who will deliver it.

The difference is the politically feasible primary balance, a concept originally introduced by Olivier Blanchard in 1984. This politically feasible primary balance determines the magnitude and pace of the fiscal adjustment that a government can realistically achieve.

Determining precisely the politically feasible primary balance is nigh on impossible. Apart from rare cases in which the tolerance limits of the public are evidenced (in the form of civil unrest), there exists no unequivocal empirical evidence of where these limits lie. In addition, tolerance


limits reflect the nature of the social contract and can shift over time. There are numerous examples of countries that, in a crisis situation (including the current one), have demonstrated a tolerance for fiscal pain well in excess of expectations.

We calibrate the politically feasible primary balance by making two simple assumptions: we consider the levels of government revenue and primary expenditure (ex-interest payments), on a cyclically-adjusted basis over a period of ten years before the crisis, a period during which the social contract can be considered to have been stable. We then assume that the maximum level of revenue that has been tolerated over that period of ten years must be within the public’s tolerance limits and can be achieved again. And we similarly assume that the minimum level of primary expenditure that has been achieved over that period can be achieved again. The difference between the two provides us an estimate of the politically feasible primary balance.

CHART 1

Determination of the maximum politically plausible primary balance (France)

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Revenue

Source: Eurostat, Moody’s

The chart above illustrates how the outcome is determined, in the case of France. The maximum plausible structural primary balance is on that calculation 3½% of GDP. This is small in comparison with other Aaa and Aa governments but would still represent a substantial effort for France. The highest level of the actual structural primary balance achieved there over the past few decades was only 1½%. The maximum plausible primary balances for Aaa governments covered in this issue of the Sovereign Monitor are provided in Table 3 below.

TABLE 3

Maximum politically feasible primary balance (% of GDP) Denmark 7½

Finland 9

France 3½

Germany 5½

Spain 5

Sweden 10

United Kingdom 6½

United States (federal government) 3½

The extent to which resolute fiscal adjustment can be achieved by governments over a given period can be derived from these balances, assuming that governments are able to maintain their primary balance at this maximum level over time (which also implies that they maintain their revenue/GDP level at the maximum level). However, growth conditions also need to be taken into account.


Growing Out of Debt? Most Aaa Governments Face Headwinds, not Tailwinds Fiscal adjustment may be facilitated by tailwinds in the form of higher growth and lower nominal interest rates paid on the debt. It can be complicated by headwinds in the form of lower nominal growth and higher interest rates. The key here is the difference between the nominal interest rates paid on the debt (natural rate of increase of the debt) and the nominal rate of growth of the economy (natural rate of growth of the government revenues).

Chart 2 illustrates the extent of these head- and tailwinds for selected countries. The Spanish government in particular benefited from very strong tailwinds as government bond yields fell around the time of the introduction of the euro and remained well below nominal growth thereafter. The US, and to some extent the UK, have also benefited from tailwinds. By contrast, despite paying lower interest on its debt than its peers, Germany faced steady headwinds as its nominal growth rate remained consistently low.

CHART 2

Spread between 5-year bond yields and nominal growth

-6

-4

-2

0

2

4

6

8

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

UKSpainGermany

FranceUS

Source: Bloomberg, Moody’s

Going forward, it cannot be assumed that the tailwinds that some countries benefited from in the past will continue. More often than not, they were associated with comparatively higher inflation or with strong credit growth, both unsustainable.

To capture the effect of growth in our estimate of a government’s reversibility margin, we make assumptions regarding nominal growth and interest rates over the medium-term. The assumptions regarding interest rates are the same as those we use in the baseline scenario underpinning our debt trajectories (see section 3 for details): we use five-year bond yields as a proxy for the cost of funding of governments and assume that these will gradually rise from current levels. For nominal growth, we use medium-term assumptions consistent with our baseline macro scenario of a muted recovery (the ‘hook’ scenario). There is an implicit assumption that nominal growth would not be undermined by a sharp fiscal adjustment as primary balances move to the politically feasible surplus as described earlier, i.e. that the private sector decreases its savings ratio to compensate for the increase of the public sector’s. If this assumption is not valid, then our estimate of the government’s reversibility margin is too generous. It still provides, however, a useful reference for rating committees.


The table below summarises the result. It shows the total improvement of debt affordability that would occur over a five-year period under the assumptions detailed above, for the countries covered in this issue of the Aaa Sovereign Monitor.

TABLE 4

Debt reversibility margin Denmark 3%

Finland 3%

France 1%

Germany 2%

Spain 2½%

Sweden 3%

United Kingdom 3%

United States (federal and general government) 4%

One interpretation of this table is that, for instance, if projections of the French government’s affordability ratio showed it to rise beyond 11%, then this would most likely have rating implications. This is because a return of the ratio to single-digit territory would appear unlikely over a foreseeable horizon, unless the French government in the meantime demonstrated a reaction capacity well above that observed so far. In the case of Germany, the reversibility margin is wider and rating implications would not necessarily take place unless the affordability ratio was projected to rise beyond circa 12%. For the UK, the upper end of the reversibility margin is even higher, at 13%.

These figures are illustrative and are not hard triggers for rating decisions, but they are intended to illustrate how much the benefit of the doubt we may give to individual governments. In each case, however, a government would only enjoy the benefit of the doubt to the extent that it resolutely intended to exploit the entire fiscal adjustment capacity that we attribute to it.


Appendix: Debt Projections

Debt Projections: Baseline Scenario Average 2004 to 2007 2008 2009 2010 2011 2012 2013 France Nominal GDP Growth 4.4 2.9 -1.2 2.5 3.2 4.5 4.0 Aaa/STA Budget Balance -2.9 -3.4 -7.9 -8.2 -6.7 -5.5 -4.5 Interest Rate 4.3 4.5 4.5 4.2 4.0 4.1 4.1 Debt/GDP 64.7 68.1 77.4 83.4 87.5 89.2 90.3 Intpaym/Revenue 5.4 5.7 6.5 6.6 6.7 7.0 7.3 Germany Nominal GDP Growth 2.9 2.8 -4.2 1.8 2.4 2.1 2.3 Aaa/STA Budget Balance -2.2 0.0 -3.0 -5.0 -4.6 -3.2 -2.2 Interest Rate 4.4 4.3 3.9 3.9 3.8 3.9 4.0 Debt/GDP 66.5 65.9 73.1 76.7 79.0 80.1 80.1 Intpaym/Revenue 6.4 6.2 6.1 6.5 6.6 6.9 7.1 UK Nominal GDP Growth 5.3 3.5 -3.5 2.6 4.0 4.5 4.5 Aaa/STA Budget Balance -3.0 -5.1 -12.1 -12.9 -10.1 -7.9 -6.1 Interest Rate 5.3 5.4 3.5 4.0 4.0 4.1 4.3 Debt/GDP 42.6 51.8 68.6 80.3 86.6 90.1 91.7 Intpaym/Revenue 5.1 5.4 4.9 6.9 7.8 8.5 8.9 US FG Nominal GDP Growth 6.0 2.6 -1.3 3.6 5.1 6.0 6.0 Aaa/STA Budget Balance -2.3 -3.2 -9.9 -10.6 -8.4 -5.2 -4.2 Interest Rate 4.6 4.9 3.2 2.5 2.9 3.3 3.8 Debt/GDP 37.2 40.2 53.0 63.6 68.6 70.8 71.7 Intpaym/Revenue 8.9 10.0 8.9 8.7 11.3 13.2 15.0 US GG Nominal GDP Growth 6.0 2.6 -1.3 3.6 5.1 6.0 6.0 Aaa/STA Budget Balance -3.2 -6.5 -11.2 -10.7 -9.4 -6.3 -5.2 Interest Rate 3.4 3.4 3.1 2.6 2.9 3.2 3.6 Debt/GDP 61.3 70.0 83.9 92.4 99.5 101.1 101.2 Intpaym/Revenue 5.8 6.4 7.1 6.9 8.1 9.4 10.6 Spain Nominal GDP Growth 7.6 4.2 -3.5 -0.3 2.8 2.3 3.2 Aaa/STA Budget Balance 1.1 -4.1 -11.7 -9.8 -7.8 -6.0 -4.2 Interest Rate 4.2 4.6 4.6 4.0 4.0 4.2 4.4 Debt/GDP 41.3 39.5 55.2 65.9 71.7 75.9 77.6 Intpaym/Revenue 4.4 4.3 5.5 6.2 7.1 8.0 8.7 Denmark Nominal GDP Growth 4.8 2.7 -3.9 3.3 3.3 4.4 4.7 Aaa/STA Budget Balance 4.1 3.4 -3.0 -5.5 -4.0 -3.2 -2.0 Interest Rate 6.5 5.6 4.6 4.0 4.1 4.3 4.5 Debt/GDP 34.9 33.4 38.5 41.8 46.2 48.3 48.1 Intpaym/Revenue 4.3 2.7 3.0 2.9 3.1 3.6 3.9 Finland Nominal GDP Growth 5.4 2.8 -5.9 0.2 4.0 5.7 5.2 Aaa/STA Budget Balance 3.5 4.4 -2.2 -4.0 -3.0 -2.2 -1.7 Interest Rate 4.0 4.4 3.9 4.0 3.9 4.0 4.1 Debt/GDP 40.1 34.2 41.8 48.3 52.2 54.3 56.1 Intpaym/Revenue 3.1 2.8 2.7 3.2 3.4 3.7 3.9 Norway Nominal GDP Growth 9.4 11.9 0.2 3.6 4.2 4.2 4.2 Aaa/STA Budget Balance 15.6 18.8 7.9 7.5 6.2 5.3 4.3 Interest Rate 3.2 3.1 2.9 2.9 3.2 3.4 3.7 Debt/GDP 49.1 50.6 50.0 49.8 40.9 33.2 26.9 Intpaym/Revenue 2.5 2.5 3.0 2.8 3.1 2.7 2.4 Sweden Nominal GDP Growth 5.1 3.0 -1.4 3.7 5.5 6.0 5.5 Aaa/STA Budget Balance 2.2 2.5 -2.1 -3.3 -2.2 -1.2 -1.2 Interest Rate 3.8 4.3 3.4 3.2 3.3 3.6 3.9 Debt/GDP 47.2 38.0 42.8 45.5 45.9 44.9 44.3 Intpaym/Revenue 3.2 3.0 2.4 2.5 2.7 2.9 3.1

Note: Interest rate refers to the effective interest rate on the country’s debt, not to the market yield. The cells shaded in light green reflect a positive revision of Moody’s estimate compared to the forecast published in the December Aaa Sovereign Monitor, the ones shaded in light red a negative revision.


Debt Projections: Adverse Scenario Average 2004 to 2007 2008 2009 2010 2011 2012 2013 France Nominal GDP Growth 4.4 2.9 -1.2 2.0 2.7 4.0 3.5 Aaa/STA Budget Balance -2.9 -3.4 -7.9 -9.2 -8.1 -7.5 -7.2 Interest Rate 4.3 4.5 4.5 4.2 4.4 5.0 5.6 Debt/GDP 64.7 68.1 77.4 84.8 90.7 94.6 98.5 Intpaym/Revenue 5.4 5.7 6.5 6.7 7.6 9.1 10.7 Germany Nominal GDP Growth 2.9 2.8 -4.2 1.3 1.9 1.6 1.8 Aaa/STA Budget Balance -2.2 0.0 -3.0 -6.0 -5.9 -4.9 -4.5 Interest Rate 4.4 4.3 3.9 3.9 4.1 4.7 5.2 Debt/GDP 66.5 65.9 73.1 78.1 82.0 85.2 87.7 Intpaym/Revenue 6.4 6.2 6.3 6.7 7.5 8.8 10.1 UK Nominal GDP Growth 5.3 3.5 -3.5 2.1 3.5 4.0 4.0 Aaa/STA Budget Balance -3.0 -5.1 -12.1 -13.9 -11.4 -9.6 -8.1 Interest Rate 5.3 5.4 3.5 4.0 4.3 4.8 5.2 Debt/GDP 42.6 51.8 68.6 81.6 89.6 95.1 98.9 Intpaym/Revenue 5.1 5.4 4.9 7.0 8.6 10.2 11.6 US FG Nominal GDP Growth 6.0 2.6 -1.3 3.1 4.6 5.5 5.5 Aaa/STA Budget Balance -2.3 -3.2 -9.9 -11.7 -9.7 -6.8 -6.3 Interest Rate 4.6 4.9 3.2 2.7 3.3 4.2 5.1 Debt/GDP 37.2 40.2 53.0 65.0 71.5 75.5 78.6 Intpaym/Revenue 8.9 10.0 8.9 9.7 13.6 17.8 22.4 US GG Nominal GDP Growth 6.0 2.6 -1.3 3.1 4.6 5.5 5.5 Aaa/STA Budget Balance -3.2 -6.5 -12.1 -11.8 -10.8 -8.1 -7.5 Interest Rate 3.4 3.4 3.1 2.7 3.2 3.9 4.8 Debt/GDP 61.3 70.0 83.9 93.9 102.7 106.4 109.1 Intpaym/Revenue 5.8 6.4 7.1 7.2 9.2 11.9 14.9 Spain Nominal GDP Growth 7.6 4.2 -3.5 -0.8 2.3 1.8 2.7 Aaa/STA Budget Balance 1.1 -4.1 -11.7 -10.8 -9.2 -7.8 -6.6 Interest Rate 4.2 4.6 4.6 4.0 4.4 5.1 5.8 Debt/GDP 41.3 39.5 55.2 67.2 74.6 80.9 85.2 Intpaym/Revenue 4.4 4.3 5.5 6.4 8.2 10.5 12.6 Denmark Nominal GDP Growth 4.8 2.7 -3.9 2.8 2.8 3.9 4.2 Aaa/STA Budget Balance 4.1 3.4 -3.0 -6.5 -5.3 -4.8 -3.9 Interest Rate 6.5 5.6 4.6 4.0 4.4 5.2 5.9 Debt/GDP 34.9 33.4 38.5 43.0 48.8 52.5 54.2 Intpaym/Revenue 4.3 2.7 3.0 2.9 3.6 4.7 5.6 Finland Nominal GDP Growth 5.4 2.8 -5.9 -0.3 3.5 5.2 4.7 Aaa/STA Budget Balance 3.5 4.4 -2.2 -5.2 -4.3 -3.8 -3.7 Interest Rate 4.0 4.4 3.9 4.0 4.3 4.9 5.5 Debt/GDP 40.1 34.2 41.8 49.5 54.8 58.6 62.4 Intpaym/Revenue 3.1 2.8 2.7 3.3 4.0 4.9 5.9 Norway Nominal GDP Growth 9.4 11.9 0.2 3.1 3.7 3.7 3.7 Aaa/STA Budget Balance 15.6 18.8 7.9 6.4 5.0 3.9 2.8 Interest Rate 3.2 3.1 2.9 3.1 3.6 4.0 4.6 Debt/GDP 49.1 50.6 50.0 51.1 43.6 37.4 32.5 Intpaym/Revenue 2.5 2.5 3.0 3.0 3.6 3.5 3.4 Sweden Nominal GDP Growth 5.1 3.0 -1.4 3.2 5.0 5.5 5.0 Aaa/STA Budget Balance 2.2 2.5 -2.1 -4.4 -3.4 -2.6 -2.9 Interest Rate 3.8 4.3 3.4 3.2 3.7 4.5 5.2 Debt/GDP 47.2 38.0 42.8 46.7 48.4 49.1 50.2 Intpaym/Revenue 3.2 3.0 2.4 2.5 3.1 3.9 4.6

Note: Interest rate refers to the effective interest rate on the country’s debt, not to the market yield. The cells shaded in light green reflect a positive revision of Moody’s estimate compared to the forecast published in the December Aaa Sovereign Monitor, the ones shaded in light red a negative revision.


Moody’s Related Research

Special Comments » Aaa Sovereign Monitor - December 2009 (121362)

» Aaa Sovereign Monitor - September 2009 (119221)

» Sovereign Risk: Review 2009 & Outlook 2010 (121695)

» European Sovereign Outlook (121440)

» France's Grand Emprunt: A Short-Term Cost for an Uncertain Long-Term Gain, November 2009 (121223)

» Why Aaa Sovereigns Get Downgraded, September 2009 (119194)

» Central Bank Exit Strategies May Gradually Exert Pressure on European Government Finance-ability, November 2009 (121480)

» Anchors in the Storm: Aaa Governments and Bank Bail-Outs, March 2008 (108164)

» What Does It Mean To Be A Triple-A Sovereign?, May 2008 (109129)

» When macroeconomic tensions result in rating changes: how vulnerable are EMEA Sovereigns?, May 2008 (109182)

» Sovereign Defaults and Interference: Perspectives on Government Risks, July 2008 (110114)

» The Unshaken Foundations of the U.S. Government's Aaa Rating, September 2008 (111526)

» Banking Crisis: European Governments Take Calculated Risks With Public Finances - But No Rating Impact Except for Iceland, October 2008 (111874)

» Rating Sovereigns During a Global "Sudden Stop" in International Funding, November 2008 (112231)

» Moody's Interprets Uncovered Aaa Government Bond Auctions, January 2009 (114012)

» Dimensioning US Government Debt, February 2009 (114559)

» How Far Can Aaa Governments Stretch Their Balance Sheets?, February 2009 (114682)

» Not All Public Debt is the Same: Navigating the Public Accounts Maze, February 2009 (114612)

» Rating Sovereign Risk Through a Once-a-Century Crisis, June 2009 (117727)

» Are Sovereigns on the Road to Recovery?, July 2009 (119222)

Issuer Comments » Moody's: Germany Well Placed to Adjust to Challenges Posed by the Global Crisis, 10

September 2009

» New Zealand Budget Raises Debt, But Aaa Rating Outlook Remains Stable, June 2009 (117684)

» U.S. Treasury's Intention to Lengthen Debt Maturity Reduces Vulnerability to Interest Rate Shocks, November 2009 (120978)

» U.S. Statutory Debt Limit to be Raised; Longer-Term Fiscal Strategy the Real Question, September 2009 (120298)

» Germany Faces Delicate Economic Rebalancing Act, May 2009 (117381)

Rating Methodology » Sovereign Bond Ratings, September 2008 (109490)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.




























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