NORTH AMERICA Crunch Time Morgan Stanley & Co. LLC Recent Reports Vincent Reinhart Vincent.Reinhart@morganstanley.com David Greenlaw David.Greenlaw@morganstanley.com Ted Wieseman Ted.Wieseman@morganstanley.com Dane M Vrabac Dane.Vrabac@morganstanley.com John Abraham John.A.Abraham@morganstanley.com Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates, which in turn make debt burdens more severe. The result will then be higher budget deficits and debt levels, possibly leading to a fiscal crunch a tipping point in which government bond rates shoot up and a funding crisis ensues. Title Date Beyond the Cliff Dec 20, 2012 David Greenlaw US Forecast Update: Still in Holding Pattern Nov 20, 2012 In the U.S., high debt levels could eventually lead to higher interest rates, thereby raising future budget deficits and debt levels well beyond official baseline projections, which in turn could raise interest rates still further. A greatly expanded Fed balance sheet carries some risks. For example, Federal Reserve remittances to the Treasury could evaporate if interest rates rise, exposing the central bank to a political attack. The combination of a massively expanded central bank balance sheet and an unsustainable public debt trajectory is a mix that has the potential to substantially reduce the flexibility of monetary policy. For important disclosures, refer to the Disclosures Section, located at the end of this report.
Crunch Time 1 David Greenlaw and John Abraham (New York) An analysis of sovereign debt dynamics reveals that countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates, which in turn make the debt problems more severe. To see this, suppose that a country s current primary surplus is less than that level needed to stabilize the level of debt-to-gdp. The government then has four options: 1) cut spending or increase revenues to increase the primary surplus; 2) do nothing so that the debt-to-gdp ratio grows even larger; 3) use unanticipated inflation to bring the debt-to-gdp ratio back down; or 4) default on the debt. If lenders doubt the feasibility of the first alternative, they will demand a higher interest rate, thereby increasing interest payments on the debt. The result will then be higher budget deficits and debt levels, possibly leading to a fiscal crunch a tipping point in which government bond rates shoot up and a funding crisis ensues. Exhibit 1 shows data for our sample of 20 advanced economies. Based on the mechanics of debt accumulation and economic growth, we calculate the level of the primary government surplus that would be required to stabilize the debt-to-gdp ratio at 2011 levels. These values are shown in the last column. If the so-called necessary surplus is sufficiently far from a country s historical experience and politically plausible levels, the government may well begin to pay a premium to international lenders as compensation for default or inflation risk. We next conducted a statistical analysis of the recent experience of these twenty advanced economies asking what factors in the prior year help predict the average yield on ten-year debt. We find that gross debt is a little more important than net debt, while the current-account deficit also matters. Importantly, as is illustrated in Exhibit 2, we also find that there is an interaction between the impact of the level of debt and the current account, as well as tipping-point nonlinearities in which the higher the debt levels and current account deficits, the greater the rise in interest rates. For example, a 1% increase in 1 This note is based on a report presented at the 2013 U.S. Monetary Policy Forum that was co-authored by David Greenlaw, James Hamilton of the University of California at San Diego, Peter Hooper of Deutsche Bank Securities and Frederic Mishkin of Columbia University. The full report, as well as comments by Boston Fed President Eric Rosengren and Federal Reserve Board Governor Jerome Powell, is available at: http://research.chicagobooth.edu/igm/events/conferences/2013-usmo netaryforum.aspx debt-to-gdp when the current account deficit is 2.5% and debt-to-gdp is 100% (the current value for the U.S.) is associated with a 6 basis point (0.06 percentage point) increase in the ten-year bond rate. By comparison, when both the current account deficit and debt-to-gdp ratio are at zero, a 1% increase in debt-to-gdp is associated with only a 1 basis point increase in the ten-year rate. Exhibit 1 Key Fiscal Indicators for 20 Advanced Economies 2012 10-year yield (%) 2011 debt/gdp (%) 2011 net debt/gdp (%) 2007-11 current acct/gdp (%) Nominal GDP growth (%) 2011 surplus (%GDP) Necessary surplus (%GDP) Country Australia 3.4 24.2 8.2-4.0 6.7-4.0-0.8 Austria 2.4 72.3 52.1 3.2 3.4-0.4-0.7 Belgium 3.0 97.8 81.4-0.2 3.4-0.6-0.4 Canada 1.9 85.4 33.1-1.6 4.2-3.9-2.0 Denmark 1.5 44.1 0.2 4.0 2.6-1.4-0.5 Finland 1.9 49.1-54.1 1.8 3.0-1.0-0.5 France 2.6 86.0 78.8-1.5 2.7-2.7-0.1 Germany 1.5 80.6 55.3 6.3 2.2 0.9-0.6 Greece 22.9 165.4 165.4-12.1 2.6-2.2 28.0 Ireland 6.0 106.5 94.9-2.2 1.6-9.6 4.5 Italy 5.5 120.1 99.6-2.6 2.0 0.8 4.1 Japan 0.8 229.6 126.4 3.4-1.0-8.9 4.1 Netherlands 2.0 65.2 31.7 6.1 2.7-3.1-0.5 Norway 2.1 49.6-168.2 13.2 5.6 11.6-1.8 Portugal 11.0 107.8 97.3-10.0 2.0-0.6 9.0 Spain 5.9 69.1 57.5-6.5 3.6-7.0 1.6 Sweden 1.5 37.9-18.2 7.7 3.9-0.8-0.9 Switzerland 0.7 46.8 25.9 9.2 2.8 0.8-1.0 U.K. 1.9 81.8 76.6-1.8 3.6-5.7-1.5 U.S. 1.8 102.9 80.3-3.7 3.5-7.8-1.8 Source: Haver Analytics, IMF, authors calculations Exhibit 2 Response of Sovereign Yields to Debt Ratios Under Alternative Current Account Balances 16% 14% 12% 10% 8% 6% 4% (Sovereign Yield, Percent) CA = 0.0% CA = -2.5% CA = -5.0% 2% (Debt to GDP, Percent) 0% 0 20 40 60 80 100 120 140 160 180 200 Note: CA is current account balance as % of GDP. Horizontal axis: gross debt as a percent of GDP in year t - 1. Vertical axis: amount by which a country s interest rate in year t would be predicted to be higher (measured in annual percentage points) compared to what the interest rate would be if debt in year t - 1 were equal to 0 for indicated levels of the current-account balance. Source: Authors calculations 2
Case studies illustrate the problems encountered historically by countries with debt above 80% of GDP and persistent current-account deficits. These countries proved to be vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics. Interest rate surges occur either because there is news that budget deficits and future debt levels are much higher than previously suspected or because a decline in economic growth leads to higher projected debt-to-gdp. The need for time-consistent budget projections makes incorporating such feedback loops difficult, and they are left out of current, official long-term U.S. budget projections (see Exhibit 3). If materialized however, it could be much more difficult for the U.S. to maintain a sustainable budget course. 2 The most recent projection from the Congressional Budget Office assumes that the yield on ten-year Treasury notes rises to a level of 5.2% as the economy recovers, and remains there, as is shown in Exhibit 4. Under current spending and tax policy, the CBO forecast calls for U.S. gross debt/gdp to rise to 107% by 2014 and decline modestly for the next several years before resuming a gradual upward ascent, reaching a level of 150% in twenty-five years (see Exhibit 5). Exhibit 3 CBO Assumptions for Federal Government Revenues and Expenditures Percent of GDP 33% 31% 29% 27% 25% 23% 21% 19% 17% Net Interest Expenditures Revenues 15% 2013 2016 2019 2022 2025 2028 2031 2034 2037 Exhibit 4 Ten-Year Bond Yields Under CBO Assumptions and Baseline Simulation Assumes Baseline Economic Conditions 10-Year U.S. Treasury Yield (Percent) 15% 12% 9% 6% 3% Simulation I CBO Projections Actual 0% 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 However, our statistical analysis shows that higher debt levels would likely lead to higher interest rates, thereby raising budget deficits and debt levels, which in turn would raise interest rates further. Simulation I in Exhibits 4 and 5 allows for this feedback effect, resulting in substantially higher interest rates and debt-to-gdp than the CBO projections. However, this simulation uses the same primary deficit baseline and economic projections as the CBO. We rerun the simulation using an alternative economic scenario (specifically, the unemployment rate falls to a long-run level of 6% rather than 5 ¼% as assumed by the CBO) and assume that the looming budget sequester is cancelled. As shown by Simulation II in Exhibits 5 and 6, the result is a rather dire situation with debt-to-gdp rising to 300% in twenty-five years and with 10-year bond yields as high as 25%. These simulations should not be taken as our predictions for what will happen to bond yields and debt levels because we surely would expect modifications in government spending and taxes, but it does illustrate the dangers if nothing is done to put U.S. fiscal policy on a sustainable path. 2 The estimates shown use the latest CBO baseline estimates through 2023, with modest adjustments to account for the treatment of the Doc fix, tax extenders and Hurricane Sandy relief. For years, 2024 through 2037, we rely on the same assumptions used in the CBO s latest Long Term Budget Outlook. 3
Exhibit 5 Gross Debt as Percent of GDP Under CBO Projections and Baseline Simulation Assumes Baseline Economic Conditions Gross Debt to GDP (Percent) Exhibit 7 Gross Debt as Percent of GDP Under CBO Projections and Alternative Economic Simulation Assumes Budget Sequester Cancelled and Higher Unemployment Gross Debt to GDP (Percent) 180% Simulation I 350% Simulation II 160% CBO Projections 300% CBO Projections 140% 250% 200% 120% 150% 100% 100% 80% 2012 2016 2020 2024 2028 2032 2036 Exhibit 6 Ten-year Bond Yields Under CBO and Alternative Economic Simulation Assumes Budget Sequester Cancelled and Higher Unemployment 10-Year U.S. Treasury Yield (Percent) 25% 20% 15% 10% 5% Simulation II CBO Projections Actual 0% 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 50% 2012 2016 2020 2024 2028 2032 2036 The preceding analysis raises several issues for the conduct of monetary policy. First, if fiscal policy is shifting in a desirable direction, from an unsustainable path to a sustainable one, easier monetary policy can play an important role in ensuring a successful outcome. Second, given a still polarized political system in the U.S., we also need to consider the implications for monetary policy of a fiscal policy that remains unsustainable. A fiscal crunch not only hurts economic growth because interest rates could rise to unprecedented levels but also because it could make it difficult for the Federal Reserve to control inflation. Unsustainable fiscal policy can force a central bank to pursue inflationary policies, which is known as fiscal dominance. If the central bank does not monetize the government debt, then interest rates will rise sharply, causing the economy to contract. Indeed, without monetization, fiscal dominance may result in the government defaulting on its debt, which would lead to a significant financial disruption, producing an even more severe economic contraction. Hence the central bank will in effect have little choice and will be forced to purchase the government debt by printing money, eventually leading to a surge in inflation. 4
Given the Federal Reserve s greatly expanded balance sheet, there is an additional channel through which a fiscal crunch can impinge on monetary policy and exacerbate inflation expectations the heretofore little-noted Fed remittances to the U.S. Treasury. In a fiscal crunch scenario occurring within the next five years, interest rates on the Fed s holdings of government debt would climb to much higher levels, and could lead to substantial losses. Exhibit 8 illustrates the impact these losses could have on the payments to the U.S. Treasury (note that, in practice, once the Fed s income drops below zero, remittances to the Treasury cease and the losses accrue in a deferred asset account). The black baseline takes into account the net interest income that the Fed earns from its balance sheet, as well as realized losses if the Fed sells assets along the lines of the exit strategy principles outlined in the June 2011 FOMC minutes. The black and dashed baseline plus 1% pt higher interest rates beginning in 2016 takes into account the larger losses on asset sales resulting from higher interest rates and suggests that the Fed would be unable to make payments to the Treasury for a number of years. While a broad assessment of the costs and benefits associated with the Fed s policy actions in recent years can certainly be used to justify an eventual downturn in remittances to the Treasury, the central bank could still find itself subject to political attacks. One way to avoid this is illustrated in the grey-dashed no asset sales line, which shows that by putting off asset sales, the Fed would only have a short period of not being able to provide remittances to the U.S. Treasury. It may be no coincidence that, over the course of recent weeks, Fed officials appear to be starting to signal a preference for the no asset sale scenario. Exhibit 8 Federal Reserve Income $Billions Baseline QE through 2014 at Current Pace Baseline plus 1% higher interest rates beg 2016 No Asset Sales 120 100 80 60 40 20 0-20 -40-60 2005 2010 2015 2020 Source: FRB, authors calculations In brief, the combination of a massively expanded central bank balance sheet and an unsustainable public debt trajectory is a mix that has the potential to substantially reduce the flexibility of monetary policy. This mix could induce a bias toward slower exit or easier policy, and be seen as the first step toward fiscal dominance. It could thereby cause both longer-term inflation expectations and the risk of overall inflation to rise. 5
Disclosure Section The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. LLC, and/or Morgan Stanley C.T.V.M. S.A., and/or Morgan Stanley Mexico, Casa de Bolsa, S.A. de C.V. As used in this disclosure section, "Morgan Stanley" includes Morgan Stanley & Co. LLC, Morgan Stanley C.T.V.M. S.A., Morgan Stanley Mexico, Casa de Bolsa, S.A. de C.V. and their affiliates as necessary. For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA. For valuation methodology and risks associated with any price targets referenced in this research report, please email morganstanley.research@morganstanley.com with a request for valuation methodology and risks on a particular stock or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY 10036 USA. Global Research Conflict Management Policy Morgan Stanley Research has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies. Important Disclosure for Morgan Stanley Smith Barney LLC Customers The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report. Important Disclosures Morgan Stanley is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Morgan Stanley Research does not provide individually tailored investment advice. Morgan Stanley Research has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. The securities, instruments, or strategies discussed in Morgan Stanley Research may not be suitable for all investors, and certain investors may not be eligible to purchase or participate in some or all of them. Morgan Stanley Research is not an offer to buy or sell any security/instrument or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities/instruments transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. If provided, and unless otherwise stated, the closing price on the cover page is that of the primary exchange for the subject company's securities/instruments. The fixed income research analysts, strategists or economists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality, accuracy and value of research, firm profitability or revenues (which include fixed income trading and capital markets profitability or revenues), client feedback and competitive factors. Fixed Income Research analysts', strategists' or economists' compensation is not linked to investment banking or capital markets transactions performed by Morgan Stanley or the profitability or revenues of particular trading desks. With the exception of information regarding Morgan Stanley, Morgan Stanley Research is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue equity research coverage of a subject company. Facts and views presented in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel. Morgan Stanley may make investment decisions or take proprietary positions that are inconsistent with the recommendations or views in this report. To our readers in Taiwan: Information on securities/instruments that trade in Taiwan is distributed by Morgan Stanley Taiwan Limited ("MSTL"). Such information is for your reference only. Information on any securities/instruments issued by a company owned by the government of or incorporated in the PRC and listed in on the Stock Exchange of Hong Kong ("SEHK"), namely the H-shares, including the component company stocks of the Stock Exchange of Hong Kong ("SEHK")'s Hang Seng China Enterprise Index is distributed only to Taiwan Securities Investment Trust Enterprises ("SITE"). The reader should independently evaluate the investment risks and is solely responsible for their investment decisions. Morgan Stanley Research may not be distributed to the public media or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong. If you have any queries concerning Morgan Stanley Research, please contact our Hong Kong sales representatives. Information on securities/instruments that do not trade in Taiwan is for informational purposes only and is not to be construed as a recommendation or a solicitation to trade in such securities/instruments. MSTL may not execute transactions for clients in these securities/instruments. Morgan Stanley is not incorporated under PRC law and the research in relation to this report is conducted outside the PRC. Morgan Stanley Research does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors shall have the relevant qualifications to invest in such securities and shall be responsible for obtaining all relevant approvals, licenses, verifications and/or registrations from the relevant governmental authorities themselves. Morgan Stanley Research is disseminated in Brazil by Morgan Stanley C.T.V.M. S.A.; in Japan by Morgan Stanley MUFG Securities Co., Ltd. and, for Commodities related research reports only, Morgan Stanley Capital Group Japan Co., Ltd; in Hong Kong by Morgan Stanley Asia Limited (which accepts responsibility for its contents); in Singapore by Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H), regulated by the Monetary Authority of Singapore (which accepts legal responsibility for its contents and should be contacted with respect to any matters arising from, or in connection with, Morgan Stanley Research); in Australia to "wholesale clients" within the meaning of the Australian Corporations Act by Morgan Stanley Australia Limited A.B.N. 67 003 734 576, holder of Australian financial services license No. 233742, which accepts responsibility for its contents; in Australia to "wholesale clients" and "retail clients" within the meaning of the Australian Corporations Act by Morgan Stanley Smith Barney Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813, which accepts responsibility for its contents; in Korea by Morgan Stanley & Co International plc, Seoul Branch; in India by Morgan Stanley India Company Private Limited; in Vietnam this report is issued by Morgan Stanley Singapore Holdings; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main and Morgan Stanley Private Wealth Management Limited, Niederlassung Deutschland, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that Morgan Stanley Research has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. LLC, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by the Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Morgan Stanley Private Wealth Management Limited, authorized and regulated by the Financial Services Authority, also disseminates Morgan Stanley Research in the UK. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International plc or Morgan Stanley Private Wealth Management representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited. The trademarks and service marks contained in Morgan Stanley Research are the property of their respective owners. Third-party data providers make no warranties or representations relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request. The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at Professional Clients only, as defined by the DFSA. The financial products or financial services to which this research relates will only be made available to a customer who we are satisfied meets the regulatory criteria to be a Professional Client. 6
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA. As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations. 7
The Americas Europe Japan Asia/Pacific 1585 Broadway 20 Bank Street, Canary Wharf 4-20-3 Ebisu, Shibuya-ku 1 Austin Road West New York, NY 10036-8293 United States London E14 4AD United Kingdom Tokyo 150-6008 Japan Kowloon Hong Kong Tel: +1 (1) 212 761 4000 Tel: +44 (0) 20 7 425 8000 Tel: +81 (0) 3 5424 5000 Tel: +852 2848 5200 2013 Morgan Stanley