Hedging bets on a eurozone debt crisis
Does Europe need more hedge funds? That was one of the more intriguing questions to come out of a one-day seminar on Europe's sovereign debt crisis I attended this week in Brussels.
The event was co-sponsored by the IMF and Bruegel, the respected European think tank, and it was held under the Chatham House Rule, which means I can't tell you who said what. But I can give you a few headlines.
The first is that George Osborne would have loved it. Everyone around the table - around two dozen senior IMF and European finance ministry officials, leading private sector economists and bond market investors - agreed that the mountain of debt sitting on governments' balance sheets was one of the biggest risks facing the global economy today.
Ed Balls would have hated it, for the same reason. No-one questioned the need for governments to rein in borrowing - and there was very little nervousness about the pace of tightening already in train. In fact, the worry was that higher debt ratios would prevent central banks from responding to the next downturn, by putting up pressure on interest rates. Their fear was that countries would get into a negative loop, where high public debt levels produce slower growth, and slower growth makes it that much harder to bring down debt.
And it gets worse: most of the economists at the meeting didn't think it was enough to simply stabilise government debt at a new, higher level, as has happened after most recessions since the war.
Much was made of recent IMF research showing that most European countries had costs coming down the track from ageing - higher pension and health spending - which could make the cost of bailing out the banks in 2008-9 look like a dry cleaning bill.
Related work by Roel Beetsma, an academic economist at the University of Amsterdam, concludes that, on average, EU governments need to run a budget surplus of 1.6% of GDP for the next two generations if baby boomers are going to come close to paying the cost of their extended old age.
Yes, you did read that right: a 1.6% budget surplus for two generations. In case you were wondering, a surplus is when the government takes in more revenues than it spends. We're not very familiar with them in the UK because they have only happened five times in the last 40 years.
This isn't the time to re-open the debate about austerity in the UK - the focus of the seminar was the eurozone, not the UK. But it was interesting that the mood of the room was so hawkish.
You might ask - where do hedge funds come into this? The answer is that the experts at the conference weren't only concerned with the long-term challenge of bringing down Europe's sovereign debt. They were also, understandably, concerned about governments' ability to finance their borrowing right now. And here, non-traditional investors like hedge funds could be more important to the eurozone in the next year or so than ministers realise.
How? Well, in the discussion about the state of play in the financial markets there was an interesting disconnect between the officials and the economists, on the one hand, and the asset managers and bankers who actually buy and sell sovereign debt.
As we know, the interest rate - yield - on government debt for problem countries like Greece, Ireland and Portugal has spiked up again over the last few months, even despite that gargantuan support programme for the eurozone announced in May.
By and large, the officials at the seminar thought this was because investors were worried about the fundamentals in these countries: their long-term growth rate and their basic ability to re-pay. But the players from the "buy-side" of the market suggested a more prosaic explanation.
Yes, they said, of course there are some concerns about Greece, and maybe Ireland's, long-term ability to avoid a debt restructuring. But the high level of the yields right now more than make up for that risk. This is doubly true of the likes of Spain and Portugal, where they judged the fundamental risks of a default to be very small.
The real problem all these peripheral governments are facing, they said, is that the big traditional buyers of government bonds - life insurance companies, pension funds, and the like - have got to the point where they can't or won't buy these assets at any price. (Or at least the foreign institutions won't - domestic institutions in these countries may continue to buy).
Sometimes it's regulation that's hurting demand for bonds: many institutional investors are simply not allowed to invest in assets after the credit rating falls below a certain level. But more often, these participants said, it's about image, and huge risk aversion. Institutions don't want to take the reputational hit of investing in a country that ends up restructuring its debt, even if it's a tiny fraction of their portfolio, and even if they actually make money on the deal.
The upshot is that even if an asset manager has got an elaborate econometric model showing that Portugal, say, is a good investment - if the client says they don't want Portugal, the manager gets out of Portugal. End of discussion. As one person said at the seminar: "it doesn't matter how high the yield is on Greek debt, if I can't sell it, why would I buy it?"
This is where the hedge funds and other non-traditional investors come in. Of course, they may not want to buy this debt either, but they don't have the same regulatory constraint to invest in super-safe assets; and, almost by definition, their clients want them to go for game-changing plays, not follow the herd.
So we could have a nice irony in the coming months. In the aftermath of this crisis, many eurozone governments have focused their rhetoric - and some of their regulatory fire - on hedge funds and short-term speculators. But if these market players are right, it's the traditional, "long-termist" investors that are now pulling out of peripheral European debt markets, causing officials in Lisbon and elsewhere so many sleepless nights.
One thing that everyone at the seminar agreed on is that the funding of European government debt over the next year or so looked pretty tight, with a massive supply of new and maturing debt chasing a limited amount of demand. That means there could be more scary market moments ahead for the likes of Ireland and Portugal.
If this great European sovereign debt train keeps running through 2010 and 2011 without some kind of funding crisis, it might have some evil hedge funds to thank.