public debt in 2020 : monitoring fiscal risks in developed markets db

8/6/2019 Public Debt in 2020 : Monitoring Fiscal Risks in Developed Markets DB

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tionaltopics

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Authors

Sebastian Becker+49 69 [email protected]

Wolf von Rotberg+49 69 [email protected]

Editor

María Laura Lanzeni

Technical Assistant

Bettina Giesel

Deutsche Bank ResearchFrankfurt am MainGermanyInternet: www.dbresearch.com

E-mail: [email protected] Fax: +49 69 910-31877

Managing Director

Thomas Mayer

The global crisis has caused a massive fiscal deterioration and

resulted in a sharp increase in developed market (DM) economies’

public indebtedness. On a GDP-weighted average, the DM public-debt-to-GDP

ratio climbed to around 104% in 2010 from roughly 77% in 2007. While the

troubled EMU peripheral countries have been pressured by markets to start

consolidating drastically, other DMs such as the US or Japan have continued to

run highly expansionary fiscal policies despite rapidly growing debt.

In our baseline scenario, which assumes a gradual tightening of fiscal

policies, the DM public debt stock is projected to rise to around 126%

of GDP in 2020 from roughly 104% in 2010. However, should fiscal

consolidation fail, public indebtedness could soar to more than 150% of GDP by

2020, according to our “no-policy-change” scenario. But also in the event of lower

growth, weaker fiscal accounts and/or higher market interest rates, the DM public

debt ratio could rise more sharply than sketched in our baseline scenario.

Fiscal policies have become unsustainable not only in a couple of

smaller EMU countries but also in some major DM economies. Many

DM economies are at the moment nowhere near short-term debt stabilisation.Therefore, lowering debt ratios to pre-crisis or prudential levels will require a

prolonged consolidation process and thus strong political support and stamina.

Apart from the EMU peripheral countries the debt outlook for the US

is particularly worrying. If US policymakers fail to agree on a more drastic

consolidation programme than presumed in our baseline scenario, the US debt

stock may climb to around 134% of GDP by 2020. As a result, the debt interest

burden could rise considerably over time and thus increasingly weigh on sovereign

creditworthiness. S&P‟s recent move to attach a negative outlook to the US

sovereign AAA long-term credit rating was a warning shot which deserves to be

taken seriously.

July 6, 2011

Public debt in 2020:Monitoring fiscal risks in developed markets

0

20

40

60

80

100

120

140

160

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20

Baseline scenario No-policy-change scenario*

Sources: DB Research, OECD, IMF, IHS Global Insight

Gross public debt, % of GDP (DM PPP GDP-weighted average)

* The no-policy-change scenario assumes no active fiscal consolidation over the outlook period. In other words, thestructural (i.e. cyclically adjusted) primary balances of the DM sample economies are assumed to remain unchanged at their2010 levels.

DM public indebtedness still rising



Current Issues

2 July 6, 2011

Contents

Page

1. Introduction .................................................................................................................................................... 3

2. Why the public debt structure matters ........................................................................................................ 4

2.1. A look at the public debt structure ......................................................................................................... 4

Public debt by currency denomination .................................................................................................. 4

Average maturity of public debt ............................................................................................................. 5

Public debt by type of interest-rate contract .......................................................................................... 6

Public debt by residency of holder ........................................................................................................ 7

2.2. Public debt risk matrix ........................................................................................................................... 8

Box 1: Our new public debt scenario framework ......................................................................................... 11

3. Public debt scenario analysis ..................................................................................................................... 13

3.1. Scenario framework and methodology ................................................................................................ 133.2. Baseline scenario ................................................................................................................................ 15

Macroeconomic and financial market assumptions ............................................................................ 15

Public-debt-to-GDP projections ........................................................................................................... 203.3. Shock scenarios .................................................................................................................................. 22

Shock scenario methodology .............................................................................................................. 22

Public-debt-to-GDP projections in a shock scenario ........................................................................... 23(a) Single real GDP growth shock scenario .................................................................................... 23

(b) Single primary balance shock scenario ..................................................................................... 23

(c) Single market interest rate shock scenario ................................................................................ 24

(d) Contingent liability shock scenario ............................................................................................. 25

(e/f) First and second combined shock scenarios ........................................................................... 26

Summary of pessimistic shock scenarios ............................................................................................ 26

Optimistic shock scenarios .................................................................................................................. 27

Box 2: Calculating fiscal consolidation needs .............................................................................................. 28

4. Fiscal consolidation needs ......................................................................................................................... 29

4.1. Stabilising debt ratios at 2010 levels ................................................................................................... 29

4.2. Lowering debt ratios to pre-crisis levels .............................................................................................. 31

4.3. Lowering debt ratios to prudential benchmarks................................................................................... 32

5. Summary and conclusions ......................................................................................................................... 33

Literature ........................................................................................................................................................... 35



Public debt in 2020: Monitoring fiscal risks in developed markets

July 6, 2011 3

1. Introduction

This study is a follow-up to our research paper “Public debt in 2020:

A sustainability analysis for DM and EM economies” (see Becker et

al. (2010)), which was published just before the EMU sovereign debtcrisis escalated in spring 2010 and which projected public debtdynamics until the year 2020 for a sample of 38 economies,consisting of 17 developed market (DM) and 21 emerging market(EM) economies. The main finding was that public debt sustainabilityhad become a serious challenge to the advanced world. Equippedwith updated figures, the main aim of this paper is to re-estimate ourdebt projections for the DM sample (see all 17 DM country names inchart 1).

Indeed, the global crisis has caused a massive fiscal deterioration inmany DM economies (see chart 1) and led to a drastic increase inpublic indebtedness. On a GDP-weighted average, the DM public-debt-to-GDP ratio climbed sharply to around 104% in 2010 fromaround 77% of GDP in 2007, a jump of more than 25% of GDP in just three years (see chart 2). Against the backdrop of growing debtsustainability concerns, financial markets have sharply repricedsovereign credit risks in many DM economies, as reflected bywidening sovereign CDS spreads (see chart 3). Especially in thetroubled EMU peripherals Greece, Ireland and Portugal, all of whichhad to seek EU/IMF aid, sovereign CDS spreads have remainedclose to or even at all-time highs (see chart 3), indicating thatfinancial markets attach a high probability to a debt restructuringscenario. However, public finances have become unsustainable notonly in these smaller EMU peripheral countries but also in somemajor advanced economies. In the US and Japan, for instance,governments have continued to post large fiscal deficits despite

already large and growing debt stocks. By contrast, other majorDMs, such as the UK, have already begun consolidating to preventpublic debt spinning out of control.

The paper is structured as follows. In Chapter 2 we take an in-depthlook at the composition of public debt, as the current crisis hasdemonstrated that not only the debt level or the fiscal balance butalso a government‟s debt structure determine a country‟s

vulnerability to crisis. We construct a public debt risk matrix thatranks countries with respect to the risks stemming from debt levelsas well as from debt structures. In Chapter 3 we use our newscenario framework, which explicitly takes a government‟s debtstructure into account, to project public debt dynamics over the next

ten years. In the baseline scenario we assume a policy of fiscalconsolidation, with the consolidation pace varying across countries.In the “no-policy-change” scenario we project the debt levels thatcould be reached by 2020 in the absence of consolidation.Moreover, we calculate “shock” scenarios which are characterisedby a more challenging economic and financial environment, as e.g.by lower GDP growth or higher market interest rates. In Chapter 4we estimate how much consolidation is needed to (a) stabilise debtstocks at current levels and (b) lower debt ratios to pre-crisis levels,or levels considered “prudent”. Chapter 5 concludes.

-5 0 5 10 15

IE

GR

US

GB

PT

ES

JP

FR

SK

IT

BE

AU

CA

DE

DK

SE

CH

DM*

2000-06 (average) 2007-10 (average)

Fiscal deficit, % of GDP

Sources: DB Research, OECD, IMF

Global crisis has causedsharp fiscal deterioration

* DM PPP GDP-weighted average.

1

60

70

80

90

100

110

94 96 98 00 02 04 06 08 10

PPP GDP-weighted average

Simple average

DM gross public debt, % of GDPDM public debt up sharply

Sources: DB Research, OECD, IMF, IHS GlobalInsight 2

0

250

500

750

1,000

1,250

1,500

1,750

2,000

2,250

U S

D E

G B

J P

F R I T

E S I E

P T

G R

January 2008 (eop)

Peak (since January 2008)

June 2011

Sources: Bloomberg, Markit, DB Research

Sovereign risk repricedsince 2008!5-year sovereign CDS, bp

3



Current Issues

4 July 6, 2011

2. Why the public debt structure matters

Even though higher indebtedness tends to make countries morevulnerable to economic and financial turmoil, CDS and bondspreads suggest that the debt level is far from being the onlydeterminant of a country‟s implied probability of default. Sovereigncredit ratings or CDS spreads, which signal the implied probability ofdefault on public debt, are only loosely correlated with the public-debt-to-GDP ratio. Structural indicators for potential market demandand the debt stock‟s shock resilience also play a role. Contrary tohighly indebted Japan for example, Greece, Ireland and Portugalhave been confronted with severe market pressures despite muchlower (albeit still large) debt ratios (see chart 4 and 5).

Even in a sample of developed markets with relatively similarmacroeconomic characteristics, sovereign CDS do not always tradein line with public debt levels (see chart 6). A likely explanation forthis apparent disconnect is that, when assessing default risks,markets consider not only the level of public debt but also itsstructure. In this chapter we take a closer look at the debt stocks ofDM economies. We analyse the debt structure and show debtcomposition by currency denomination (local vs. foreign), bymaturity (short vs. long term), by type of interest-rate contracts(fixed, floating, inflation-linked) and by residency of creditors(internal vs. external). In a second step, we develop a public-debtrisk matrix, which ranks countries according to their solvency anddebt structure indicators.

2.1 A look at the public debt structure

Public debt by currency denomination

The foreign currency exposure is paramount among risks inherent inthe debt structure because of the material debt reset effects localcurrency devaluations could have on the public-debt-to-GDP ratio.Rapid and unexpected devaluations repeatedly caused severedistress or default in EMs, as for instance in the Argentinian crisis of2001/2002 (see “The Argentinian crisis of 2001/02” in the box onpage 5). As most DMs are home to internationally accepted reservecurrencies they enjoy a major advantage over most EMs. Theyneither need to peg their currencies to a stronger foreign currencynor do they have to issue foreign currency (FCY) debt. Thus, thepotentially most severe single market risk factor to a country‟s public

debt stock, a rapid and unexpected exchange-rate movement, isonly of minor concern for most DMs.

In our DM sample only Sweden, Denmark and Canada have issuedsignificant shares of public debt in foreign currencies (see chart 7 onpage 5). Unlike other countries in our sample, their currencies arenot considered international reserve currencies. Higher marketliquidity in reserve currency markets may be one of the reasons tosearch for funding in major currencies.

1

In Sweden, where a foreign currency share of 15% is targeted, FCYgovernment debt accounted for around 14% of total public debt in2010. Since the onset of the global financial crisis, the Danishgovernment increased its amount of outstanding FCY debt to 11.8%

1

The larger number of market participants minimises bid-ask spreads andcorrespondingly the interest rate or bond yield a government issuer has to offer.Besides budget financing, governments may want to signal their commitment to anexisting currency peg. By tying the debt burden to the stability of the localexchange rate they can increase the credibility of an existing currency peg.

0

25

50

75

100

125

150

175

200

225

90 92 94 96 98 00 02 04 06 08 10

GR IE PT JP

Gross public debt, % of GDP

It's not only the governmentdebt level that matters for sovereign risk perception

Sources: OECD, IHS Global Insight 5

0

500

1,000

1,500

2,000

2,500

07 08 09 10 11

GR IE PT JP

5-year sovereign CDS, bp

Source: Bloomberg

Sovereign CDS: Blownout in EMU peripherals,up modestly in Japan

4

AU JPIT

ES

IEPT

GR

0

500

1,000

1,500

2,000

2,500

0 50 100 150 200

Sources: OECD, Bloomberg, Markit, DB Research

This analysis is based on our DM sample, whichconsists of 17 DM economies.

X: Gross public debt, % of GDP (2010),Y: Sovereign CDS spread, bp (June 2011)

Public debt vs. sovereignCDS spreads

6




July 6, 2011 5

The Argentinian crisis of 2001/02

In the case of Argentina‟s sovereign default in

the early 2000s, the government‟s high share

of FCY debt made the government debt

burden unbearable as soon as markets

started to doubt the credibility of the peso‟s

peg to the US dollar. The peg was abandonedstraight after sovereign default. One reason

for the loss of credibility was Argentina‟s weak

export performance (against the backdrop of

high import growth) and its related current

account deficits throughout the 1990s, which

led to rising external debt. Generally, a large

and competitive export sector is vital for a net

external (FCY) debtor country because it

generates hard-currency revenues and hence

secures the government‟s ability to honour its

FCY obligations. Overall, a country should

borrow only as much in foreign currencies as

its economy is able to generate and hence to

repay. In other words, currency mismatches

between the government‟s liablities andrevenues should be limited.

of total general government debt in 2010. Besides direct europurchases, FCY debt issuance was used as an instrument toenlarge the central bank‟s foreign currency reserve holdings,

material to the stability of the krona‟s narr ow peg to the euro. InCanada, FCY debt accounted for 3.5% of general government debtin 2010. Most of Canada‟s foreign currency funding is met through

foreign currency swaps. In 2009, however, for the first time in adecade the Canadian DMO issued two foreign currency bonds. Theproceeds of the USD 3 bn and EUR 2 bn issues were exclusivelyused to increase Canada‟s foreign exchange reserves. Given thatSweden, Denmark and Canada are home to large and competitiveexport industries, a gradual depreciation of their currencies would beunlikely to lead to a large increase in their public-debt-to-GDPratios.

2This is a major difference to the risks found in some EM

economies (for a detailed discussion on currency mismatches in EMcountries see for instance Becker (2011) page 8).

Average maturity of public debt

The nominal interest rate which a government effectively pays on itspublic debt is not only determined by prevailing market interest ratesbut also by the pace at which changing market conditions affectcoupon payments on outstanding government securities. Themarket interest rate is determined by the official policy rate, which isset by the central bank, inflation expectations as well as the defaultrisk premium demanded by investors. The share of debt that adjuststo new market conditions depends on the amount of variable-interest-rate and inflation-linked debt as well as on the amount ofmaturing fixed-interest-rate debt that needs to be rolled over atmarket interest rates. Increased short-term debt issuance cansignificantly reduce a government‟s effective interest rate. However,

over-reliance on short-term debt poses significant roll-over risks andleaves a sovereign exposed to rising market interest rates.

A shift towards short-term debt is generally observed at times ofcrisis. The reason is twofold. First, short-term borrowing becomesrelatively cheaper than long-term borrowing thanks to crisis-inducedmonetary policy easing (see chart 8). Second, short-term debtmarkets become much easier to tap for most debtors during periodsof stress than longer-term markets, especially for those borrowerswith relatively poor credit standings. Long-term yields react lesssensitively to interest rate cuts by central banks due to a variety offactors. Future growth and inflation expectations tend to be higherand the default risk premium usually rises with the length of a debtinstrument‟s maturity. Furthermore, if a country faces severe marketpressure, increased short-term borrowing itself may cause long-termyields to rise because short-term debt holders are more likely to berepaid than long-term debt holders. The combined effect is aconsiderable steepening of the yield curve, making short-term debteven more attractive to long-term debt.

De Broeck and Guscina (2011) find that the share of short-term debtissuance in total debt issuance from the second half of 2008 to theend of 2009 increased in 11 out of 16 EMU sovereigns compared tothe 1 ½-year pre-crisis period. In Belgium, for example, the share ofT-bills in total debt issuance increased to 50.7% from 21.3%. Irelanddid not issue T-bills at all in the 1 ½ years before the crisis.

2In Sweden, for instance, where the local currency depreciated by 15% in 2009 asa result of the financial crisis, the rise in the public-debt-to-GDP ratio remainedmanageable and the country became one of the fastest growing DM economies in2010, partly thanks to local currency depreciation and strong export performance.

0

1

2

3

4

5

6

07 08 09 10 11

Fed funds target rate

3-month US T-Bill yield

10-year US Treasury yield

Sources: IHS Global Insight, DB Research

%

US short-term rates stillway below long-term rates

8

14.0

11.8

3.5

1.9

1.5

1.30.6

0.3

0.2

0.1

0 5 10 15

SE

DK

CA

GR

ES

PTCH

SK

BE

IT

FCY debt, % of total public debt (2010)

Public debt by currency

Sources: National sources, OECD, Bloomberg,

DB Research 7



Current Issues

6 July 6, 2011

However, from the second half of 2008 to the end of 2009 the shareof short-term to total debt issues stood at 47.4%. At the end of 2010the US (4.7 years), Australia (4.9 years) and Japan (5.7 years) hadthe shortest average maturities among our sample economies, whilethe UK (13.4 years), Denmark (7.8 years) and Italy (7.2 years) hadthe longest average maturities (see chart 9). In Greece, the averagematurity shortened over recent years, from 8.5 years in 2007 toaround 7.1 years at the end of 2010. Over the course of 2010 morethan ¾ of Greek issues were T-bills with maturities of below oneyear.

Public debt by type of interest-rate contract

Investor preferences can have a major effect on a country‟s debt

structure. For example, in the UK Gilt market, domestic pensionfunds and insurance companies play an important role, as reflectedby the 28% share they hold in the outstanding Gilt market. In order

to match their liability structure they demand long-term, inflation-linked assets. The British debt management office (DMO) is meetingthose demands. It was the first DMO that issued inflation-linkedsecurities. The purchase of the first linkers in the early 1980s wasrestricted to domestic pension funds. It was not a coincidence thatthey were issued after a prolonged period of high inflation. Tying theinterest expenditure to inflation was designed to make inflationarypolicies less desirable for a government and hence dispel inflationworries of long-term investors. In 2010 around 22% of outstandingUK Gilts were linked to the domestic inflation rate, with maturities of10 years and more (see chart 10). The largest inflation-linked marketworldwide, however, is the US Treasury Inflation Protected

Securities (TIPS) market. With a volume of more than USD 600 bn,TIPS account for a significant share of total US Treasury (UST) debt(see chart 11).

Elsewhere in Europe, Sweden was the first country to issueinflation-linked bonds in 1994. The Swedish DMO targets a constantinflation-linked debt share of 25% of total debt. Right now 20% ofoutstanding debt is linked to domestic inflation, according to theSwedish DMO. Insurance companies and pension funds, as in theUK, are the dominant investor groups in the Swedish inflation-linkedgovernment bond market. They hold more than two-thirds ofSwedish inflation-protected debt. France issued its first inflation-indexed bonds in 1998. Driven by low inflation rates, the share ofFrench inflation-protected debt issuance fell to 7.5% of totalissuance in 2009, the lowest level since 2001. For 2010 the FrenchDMO set a target of 10% of total issuance, reflecting the increasingdemand for inflation-hedged instruments after the crisis. A similar

4.74.95.75.85.96.26.36.36.56.76.86.97.17.27.2

7.8

13.4

0

2

4

6

8

10

12

14

16

USAUJPPTCASESKDEBEESIECHGRFRITDKGB

Sources: National sources, OECD, Bloomberg, DB Research

Average maturity, years (2010)Public debt by maturity

9

0 20 40 60 80 100

GR

GB

SE

IT

FR

SK

AU

US

JP

CA

IE

DE

DK

BE

ES

PT

CH

Fixed-interest-rate debt

Floating-interest-rate debt

Inflation-linked debt

% of total public debt (2010)

Sources: National sources, OECD, DB Research

Public debt by type of interest-rate contract

10

0

2

4

6

8

10

12

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100

200

300

400

500

600

700

00 01 02 03 04 05 06 07 08 09 10 11

USD bn (right) % of total* (left)

Sources: IHS Global Insight, US Treasury

* gross marketable, interest-bearing UST debt.

UST inflation-indexed notes and bonds

UST inflation-linked debtshare has shrunk

11




July 6, 2011 7

observation could be made in several DMs. In the US, for instance,the inflation-linked debt share shrank to around 7% of grossmarketable interest-bearing UST debt from more than 10% in2007/08 (see chart 11 and 12), presumably driven by subdued USinflation expectations in the aftermath of the crisis, evidenced by analmost closed spread of 10-year UST yields over 10-year US TIPS

yields in late 2008/early 2009 (see chart 13). However, risinginflation expectations are likely to boost demand for DM inflation-protected government debt again (see Blommestein, 2011). Thisdevelopment can be regarded as favourable with respect togovernments‟ incentives to decrease their debt stocks by acceptinghigher inflation rates.

Public debt by residency of holder

To minimise risks, a DMO should preferably issue domestic-currency-denominated, fixed-interest-rate government securitieswith long maturities to a strongly committed creditor group. A strongand affluent domestic funding base proved valuable for several

highly-indebted sovereigns in the past. In this regard, the Japanesecreditor structure is outstanding. Even though the gross governmentdebt level currently stands at around 200% of GDP, the annual fiscaldeficit is forecast to remain above 7% of GDP until 2013 and realGDP growth has averaged only 0.7% p.a. since 1997 (which makesfuture fiscal consolidation very challenging), 10-year Japanesegovernment bonds (JGB) yielded less than 1.2% in June 2011. TheJapanese government enjoys the advantage that it can resort to acash-rich domestic population which gladly finances its fiscaldeficits. At 376% of disposable income in 2009, Japanesehouseholds‟ net financial wealth was higher than in any other largeDM country. The deep pool of domestic savings and the largepublicly-owned financial sector provide a very strong and reliantfunding base. More than 90% of general government debt is held byJapanese domestic investors and more than 50% was held by thebroader public sector in 2009.

3

The resilience of Japanese debt has repeatedly been demonstrated.Neither the March earthquake and its economic impact, norrepeated rating downgrades by major rating agencies put upwardpressure on JGB yields. Although an internationally diversifiedcreditor structure minimises direct domestic spill-over effects fromone sector to another and presence in international marketsincreases liquidity, close ties with a rich and only moderatelyleveraged domestic financial sector may be crucial to fund thegovernment in times of distress.

3See Fitch (2010), p. 1.

0

5

10

1520

25

30

00 01 02 03 04 05 06 07 08 09 10

US FR GB

GR AU SE

% of total public debt

Sources: National sources, OECD, DB Research

Inflation-linked public debtof selected DM countries

12

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0

1

2

3

4

5

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07 08 09 10 11


10-year US TIPS yield10-year UST yield minus TIPS yield, pp.


%

US bond yields point tomild inflation expectations

13

67615959

5447

4339

322928282625

18

87

0

10

20

30

40

50

60

70

GRIEPTBEFRDEESITUSDKSEAUSKGBCACHJP

External debt, % of total public debt (2010)

Sources: National sources, JEDH, DB Research

Public debt by holder

14



Current Issues

8 July 6, 2011

The European countries with notorious current account deficits,Greece and Portugal, as well as Ireland, mostly relied on financingfrom foreign creditors in the past. As shown in chart 14 on page 7,public-external debt accounted for 67%, 61% and 59% of total debtin Greece, Ireland and Portugal, respectively, by the end of 2010.

4In

the above three countries external funding ran dry in 2010/11 and

could not be offset by the respective domestic financial sectors.These governments ultimately required external help in the form ofEU/IMF-led bail-out programmes.

The US is a special case in terms of foreign debt holdings andvulnerability. Different to Japan, a large share of US governmentdebt is held by foreign creditors and different to peripheral Europeancountries, it is unlikely that the US will experience a sudden stop ofexternal funding due to its systemic importance for the globaleconomy. The amount of UST debt held by non-residents has risennoticeably over the past decade to around 18% of total (or 29% ofmarketable) UST debt in April 2011, from just 11% (20%) in early2000 (see chart 15), mainly as a result of large UST purchases by

Asian countries, especially Japan and China. Rising foreignparticipation in the US government bond market seems to havecontributed to the gradual fall in UST yields over recent decades andyears (see chart 16). Moreover, liquidity or roll-over risks arisingfrom the large Asian holdings of UST are probably contained, giventhat an abrupt sale of these holdings would lead to significant lossesfor Asian investors.

Other economies with relatively high public-external debt shares areBelgium (59%) and France (54%) (see chart 14 on page 7). Highlyindebted Italy can be found together with Spain and the US in themid-range of our sample economies with external debt shares ofbetween 30% and 45% of total public debt in 2010. Overall, the

ongoing EMU sovereign debt crisis suggests that a well-fundeddomestic investor base provides a strong backstop if liquidity and/orsolvency concerns about a government arise. However, stretchingthe capacity of this backstop too far could result in even higherlosses if distress eventually occurs at a later point in time.

2.2 Public debt risk matrix

As explained in the previous sections, not only solvency indicatorsbut also the structure of public debt determine a country ‟s

vulnerability to sovereign debt crisis. In order to gauge which of the17 economies of our DM sample are the most/least vulnerable tosovereign debt crisis we construct a public debt risk matrix which is

based on two different kinds of risk indicators.The first indicator, the debt-structure indicator , captures the risksinherent in a country‟s public debt structure, i.e. it indicates howvulnerable a country is with respect to market and liquidity risks. Itreflects reliance on external creditors, the average maturity of publicdebt outstanding, as well as the shares of floating-interest-rate andinflation-linked debt in total debt. A country with relatively largepublic external debt, a short average maturity as well as a highshare of variable-interest-rate and inflation-protected debt wouldobtain a relatively poor score. On the contrary, a country with lowreliance on external debt, a long average maturity as well as no orlittle floating-interest-rate and inflation-linked debt would receive a

4External debt statistics record debt liabilities at market values. Due to significantchanges in the market value of Greek, Portuguese and Irish outstanding debt in2010, we adjusted their respective nominal external debt values accordingly. SeeAnderson, Jeffrey and Jared Bebee (2011).

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00 01 02 03 04 05 06 07 08 09 10 11

USD tr (right)

% of gross marketable debt (left)

% of gross total debt (left)

Sources: IHS Global Insight, US Treasury, Fed

UST securities held at the FederalReserve Banks by foreigners

External UST debt has risenover the past decade ...

15

10

15

20

25

302

4

6

8

10

90 92 94 96 98 00 02 04 06 08 10

10-year US Treasury yield, % (left)

US Treasury securities held byforeigners, %* (inverted scale, right)

Sources: IHS Global Insight, Fed, DB Research

* of total UST gross marketable debt.

Large UST purchases byforeigners, lower US yields

16




July 6, 2011 9

relatively good score. The debt-structure indicator has a scalebetween 1 and 17, with 1 being the best and 17 being the worstscore. The largest weight was given to the external debt share,followed by the average maturity and the share of variable-interest-rate and inflation-protected debt.

The second indicator, the debt level and dynamics indicator ,captures standard solvency indicators such as a government‟s debt

level and contingent liabilities from the banking sector (see chart 17)as well as the primary balance and net debt interest payments (seechart 18). Again, the indicator has a scale from 1 (best) to 17(worst).

According to our public debt risk matrix (see chart 19), Greeceappears to be the most vulnerable country as it scores poorly withrespect to both indicators. At the other end of the spectrum,Switzerland and Denmark are the least vulnerable countries. Otherrelatively risky countries are Portugal, Ireland and the US. For theUS there are a couple of important risk mitigants, however, which

are not quantifiable and thus not captured in our simple indicator-based approach. For instance, the US dollar‟s reserve currency

status or the generally high flexiblity of the US economy somewhatreduce its vulnerability to a public debt crisis.

Japan appears to be less vulnerable than any of the three EMUperipheral countries thanks to a relatively safe debt structure as e.g.characterised by a very low external debt share. But also based onthe debt level and dynamics indicator, Japan is doing better thanGreece, Portugal and Ireland (see chart 19). Although Japan had byfar the largest gross public debt stock at almost 200% of GDP in2010, its contingent liabilites from the banking sector appear to bemuch lower than in, for instance, Greece, Ireland and Portugal (seechart 17). Moreover, against the backdrop of large governmentassets, such as the BoJ‟s sizable foreign exchange reserves,Japan‟s net government debt stood at around 116% of GDP in 2010and hence was much lower than gross government debt (see chart20 on page 10).

0 50 100 150 200 250

AU

SK

CH

SE

DK

CA

ES

DE

US

FR

BE

GB

PT

IT

GR

IE

JP

Gross public debt

Contingent liabilities

% of GDP (2010)

Sources: DB Research, OECD, S&P's, IFS

Japan had by far the largestpublic debt stock in 2010

* Contingent liabilities from the banking sector areDBR estimates based on IFS data and grossproblematic assets (GPA) estimates by S&P's.

17

-5 0 5 10 15 20 25 30 35

IE

US

GR

GB

ES

PT

JP

SKFR

AU

CA

IT

BE

DE

DK

SE

CH

Net debt interest paymentsPrimary deficit

Source: OECD

Fiscal deficit (2010) by sub-components,% of GDP

Ireland had the widestfiscal deficit in 2010

18

CH

JP

DK

GB

CA

PT

SK

ES

IT

DE

IE

BE

AU

FR

USA

SE

GR

0

2

4

6

8

10

12

14

16

0 2 4 6 8 10 12 14Debt-structure indicator

D e b t l e v e l a n d d y n a m i c s i n d i c

a t o r

Average ranking of countries: From 1 (best) to 17 (worst)

Source: DB Research

Public debt risk matrix

19



Current Issues

10 July 6, 2011

Furthermore, despite its extremely large gross public debt stock theJapanese government still has one of the lowest net debt interestexpenses thanks to a combination of very low nominal effectiveinterest rates it has to pay on gross debt as well as significantinterest income it receives on public assets. While Japan‟s gross

government interest expenses stood at around 2.8% of GDP in

2010, its net debt interest payments accounted for a much lower1.4% of GDP and hence was just half of gross interest expendituresin 2010 (see chart 21).

Although our public debt risk matrix is able to indicate which of our17 sample economies are the countries most/least prone toimminent debt crisis, it does not say anything about a country‟s

absolute risk level to run into sovereign debt problems over themedium to long term. In the next two chapters we will thereforeaddress the question of which countries are doing well in terms ofmedium to long-term public debt sustainability and which countriescould run into debt problems at a later point if they failed toconsolidate.

-50 0 50 100 150 200

SE

DK

CH

AU

SK

CA

ES

DE

GB

FR

IE

US

PT

BE

IT

GR

JP

Gross Net

Public debt, % of GDP (2010)

Source: OECD

Japan has the largestpublic debt stock ...

20

0 1 2 3 4 5 6

SE

CH

DK

CA

SK

AU

JP

ES

US

DE

FR

IE

GB

PT

BE

IT

GR

Gross Net

Debt interest payments (2010), % of GDP

... but one of the lowestlevels of net debt interestpayments

Sources: OECD, IHS Global Insight 21




July 6, 2011 11

Box 1: Our new public debt scenario framework

In Becker et al. (2010), “Public debt in 2020: A sustainability analysis for DM and EM economies”, we basedour public debt sustainability framework on the basic concept of public debt arithmetics, which required

assumptions on real GDP growth, the primary balance and the real interest rate. The average real interest ratepaid on public debt is difficult to calculate because of a heterogeneous debt structure. Usually a governmenthas outstanding debt and also continuously issues new debt at different maturities (short/medium vs. long-termdebt), in different currencies (domestic vs. foreign debt) and/or at different types of interest-rate contracts(fixed, floating vs. inflation-linked debt). As a result, there is no single interest rate that represents agovernment‟s ultimate borrowing costs. While Becker et al. (2010) approximated a government‟s relevant real

interest rate via the prevailing CPI-deflated benchmark government bond yield, we now introduce a newframework which explicitly models a sovereign‟s average real interest rates paid on public debt, taking into

account the structure of that debt.

Our new debt sustainability framework is derived from Ley (2005) and based on Becker (2011), who describespublic debt dynamics in a two currency (domestic vs. foreign)/two sector (non-tradable vs. tradable GDP)

framework that explicitly differentiates between the contractual type of interest rates (fixed vs. floating) and thestructure of local-currency-denominated debt (straight vs. inflation-protected debt) and considers the averagematurity of a country‟s public debt stock. Most DM economies issue the bulk of their public debt in domesticcurrency, so DM public debt stocks are generally unaffected by debt reset effects stemming from currencyfluctuations. Therefore, we simplify Becker‟s two currency/two sector framework into a single currency/single

sector public debt sustainability model.

1. Public debt dynamics

The starting point of our analysis is the ex-post period budget constraint of the government:

)1(11

11

,

t t t

t t

t eff

t m pbd g

id

where d denotes the public-debt-to-GDP ratio, ieff captures the nominal effective interest rate paid on publicdebt outstanding, g and π stand for the real GDP growth rate and the change in the GDP deflator (which is inthe following approximated by domestic inflation) and pb and Δm represent the primary balance (i.e. the fiscalbalance before net debt interest payments) and seigniorage (i.e. the change in the base-money-supply-to-GDPratio), respectively. Finally, t denotes the respective year of each variable.

As apparent from equation (1), the current public-debt-to-GDP ratio depends on the debt stock of the previousyear as well as on the current macroeconomic and financial environment and public finances. Generally, strongreal GDP growth and a positive change in the GDP deflator (i.e. positive inflation), a low nominal effectiveinterest rate and sound fiscal policies (as reflected by primary surpluses) are prerequisites to keep public debtdynamics in check.

2. Nominal effective interest rates

The nominal effective interest rate paid on public debt is determined by a host of factors such as the prevailingmarket interest rates, the average maturity of the debt stock (which determines how quickly changes in market

interest rates affect the nominal effective interest rate) as well as the domestic inflation rate. As thecomposition of debt plays a crucial role in the determination of the nominal effective interest rate, one needs todifferentiate between the contractual type of interest payments (floating, fixed, inflation-linked), and also needsto consider the average maturity of outstanding debt.



Current Issues

12 July 6, 2011

The nominal effective interest rate (i eff ) can be expressed as:

)2(1ˆ,

,,,

h

t eff t t eff t eff iii

where is the share of inflation-protected debt to total debt, is the domestic inflation rate and xh

eff i, is the

effective base (i.e. “real”) interest rate component paid on inflation-linked debt. As apparent from equation (2),the higher the share of inflation-protected debt to total debt ( Х ) the higher the inflation-related compensationcosts on inflation-protected debt (in the case of a positive inflation rate).

The weighted nominal effective interest rate before inflation compensation costs is given by:

)3(1ˆ,

,

1,

,,

h

t eff

h

t eff t eff

iii

As shown in equation (3), the weighted nominal effective interest rate before inflation compensation costs

hinges on (a) the effective base interest rate component on inflation-protected debt ( xh

eff i , ) and the nominal

effective interest rate on non-inflation-protected debt ( xh

eff i 1, ) debt and, on (b) the shares of inflation-protected

(Х) and straight debt (1-Х) to total debt.

Finally, let us show how the above-mentioned effective interest rates ( xh

eff i , , xh

eff i1, ) are determined, i.e. how

quickly they adjust to changes in market interest rates.The individual effective interest rate that is paid on the different slices of debt (i.e. on non-inflation-linked aswell as inflation-linked debt) is given by:

)4()1( 1,,

j

t eff

j

t

j

t eff i pi pi

where:

,;1, hh j

)5( p

As shown in equation (4), the effective interest rate on the different slices of debt is the weighted average of

the prevailing market interest rate (j

t i ) and the effective interest rate of the previous year (

j

t eff i

1, ). As also

apparent from equation (4), the higher the share of debt that is (on average per year) subject to new financialmarket conditions (p) the more sensitively the effective interest rate reacts to changing financial marketconditions. Moreover, as shown in equation (5)

1, the share of debt that adjusts on average per year to new

market conditions (p ) depends on both the share of floating-rate-debt in total debt (ω) and the share of debtthat has to be rolled-over per year ( μ ), which is given by the reciprocal value of the average maturity ofoutstanding debt. As part of floating-interest-rate-debt has to be rolled over each year anyway, we have tosubtract the cross-product of μ and ω in order to avoid double-counting.

____________________

1Equation (5) applies to non-inflation-protected debt only. In the case of inflation-linked debt, the share of debt that adjusts to new marketinterest rates is solely given by μ as there is generally no floating-interest rate component on inflation-protected debt.

Weighted nominaleffective interest

rate before inflationcompensation

Inflationcompensationcosts on CPI-

linked debt

Base (i.e. “real“) interestrate component oninflation-linked debt

Interest ratecomponent on non-inflation-linked debt




July 6, 2011 13

3. Debt scenario analysis

By plugging equation (2) into equation (1), we obtain the following expression:

)6(

)1()1(

1ˆ11

,

,,

t t t

t t

xh

t eff t t eff

t m pbd g

iid

As apparent from the right-hand side of equation (6) the current year‟s public-debt-to-GDP ratio depends onthe previous year‟s public-debt-to-GDP ratio, the current nominal effective interest rate, the current real GDPgrowth rate, the current inflation rate, the current primary balance and current seigniorage. From equation (6)we can now see that, ceteris paribus , there would be an increase (decrease) in the public-debt-to-GDP ratio bythe end of this period if (a) the real GDP growth rate decreases (increases), (b) the inflation rate decelerates(accelerates), (c) the primary balance deteriorates (strenghtens) and/or (d) seigniorage decreases (increases).

As regards the direct effects of inflation on the public-debt-to-GDP ratio, the lower (higher) the share ofinflation-linked debt to total debt the more (less) a country‟s public-debt-to-GDP ratio falls, ceteris paribus ,when domestic inflation accelerates. On the one hand, a country which has 100% of its public debt outstandinglinked to the domestic inflation rate will not be able to lower the public-debt-to-GDP ratio via higher inflation. Onthe other hand, a country which has no inflation-linked debt at all will benefit most significantly from a fallingpublic-debt-to-GDP ratio in the case of accelerating inflation. However, one should also bear in mind thathigher domestic inflation will most likely lead (either immediately or with a time lag) to “second-round” effects

such as a general rise in market interest rates as investors demand a larger inflation and/or risk premium. Asseen in (4) and (5) the shorter (longer) the average maturity of public debt outstanding, the stronger (weaker)the adverse interest-rate effect. Moreover, in the event of an active inflationary monetary policy (that aims toproduce higher inflation rates to decrease the real value of public debt) one would also need to take the centralbank‟s seigniorage from printing more money into account when carrying out a cost-benefit analysis of higher

inflation.

Note: As regards our public debt sustainability scenario analysis presented in this chapter, we omitted the seigniorage term ( Δm) of equation (6) for simplicity.

3. Public debt scenario analysis

In this chapter we analyse public debt dynamics in the 17 DMsample economies over the outlook period 2011-20. This analysisgives an update to our public debt projections presented in previous

research (see “Public debt in 2020: A sustainability analysis for DMand EM economies”).

3.1 Scenario framework and methodology

As discussed in the previous chapter, a favourable public debtstructure can be an important mitigant for sovereign debt risks. Viceversa, a precarious debt structure can expose a country to highmarket and roll-over risks. The following debt sustainability analysisis based on our new scenario framework that explicitly models acountry‟s debt structure. For instance, our new framework considersthe average maturity of government debt as well as the proportion offloating-interest-rate debt in total debt outstanding, and thus

implicitly accounts for the speed at which a sovereign‟s nominaleffective interest rate adjusts upwards to higher market interestrates. Furthermore, our model takes the share of inflation-protecteddebt to total debt into account, and hence is able to gauge the

Weighted nominal effectiveinterest rate before inflation

compensation

Inflationcompensationcosts on CPI-

linked debt

Inflation benefits/ costs



Current Issues

14 July 6, 2011

ultimate effects of higher or lower inflation on the debt-to-GDP ratio.For readers who are interested in the underlying framework, atechnical description is given in Box 1 on page 11-13.

In our baseline scenario we calculate possible outcomes for our DMsample economies‟ public-debt-to-GDP ratios over the the next ten

years in the absence of major financial as well as real economicshocks. In the baseline scenario fiscal consolidation is presumed toadvance gradually over the next ten years, with the pace ofconsolidation varying across countries. We also assess DM publicdebt dynamics in four adverse single-variable shock scenarios aswell as in two adverse combined shock scenarios.The aim of theadverse shock scenario analysis is to obtain an idea of the levelswhich public-debt-to-GDP ratios could reach in a more challengingeconomic and financial market environment. In the single-shockscenarios we consider (a) a real GDP growth shock, (b) a primarybalance shock, (c) a market interest rate shock, and (d) a contingentliability shock in which the government is forced to provide financialassistance to the banking sector. How should our adverse shock

scenarios be interpreted?

The single-shock scenarios serve as a sort of sensitivity analysis toa country‟s public debt dynamics with regard to isolated deviations inthe underlying macroeconomic and financial variables from theirbaseline numbers. In the growth shock scenario, for example, wecalculate a country‟s possible future debt path using lower real GDPgrowth forecasts than in the baseline scenario but leaving theforecasts for the remaining variables (i.e. inflation, market interestrates, primary balance) unchanged.

Scenario (a) can be understood as a low-growth scenario in whichthe economic activity is restricted by domestic and/or global factorssuch as renewed global recession. Scenario (b) captures weaker-than-expected public finances which could arise from slumpingpublic revenue and/or rising primary expenditure, for instance,driven by weaker-than-expected tax collection and/or higher socialgovernment expenditures. In shock scenario (c) sovereign bondyields, which have been relatively low over the past few yearsthanks to weak growth, monetary expansion and subdued inflationexpectations (see chart 22), are assumed to rise sharply over theoutlook period. For instance, investors could become increasinglyconcerned about long-term fiscal solvency and hence demand muchhigher default risk premia on government securities. Furthermore,bondholders could demand a much higher inflation risk premium asthey fear governments could opt to fight large public indebtedness

with higher inflation. Finally, in scenario (d) governments facefinancial-sector bail-out costs as part of the banking sector assetsbecome problematic (see chart 23). Although the single-variableshock scenarios are useful in revealing country-specific weaknessesto certain shocks, it is more appropriate to assume that any shockwill affect most macroeconomic or financial variables at the sametime. To take account of such a scenario we conclude by runningtwo combined shock scenarios. In (e) the first combined shockscenario we project public debt dynamics using lower real GDPgrowth, a weaker primary balance, higher market interest rates aswell as higher consumer price inflation. While consumer priceinflation is assumed to decelerate in the first combined shock

scenario (deflationary world) due to large output gaps, it is assumedto accelerate in (f) our second combined shock scenario because ofthe lagged effects of abundant monetary liquidity and rising publicindebtedness.

0

1

2

3

4

5

6

7

8

00 01 02 03 04 05 06 07 08 09 10 11

Fed funds target rate


ECB refi rate10-year Bund yield

%


Monetary expansion haskept bond yields low

22

0 50 100 150 200 250 300

SK

US

JP

BE

GR

DE

AU

CA

IT

FR

SE

CH

GB

PT

ES

DK

IE

DM*


Private-sector credit, % of GDP (2010)

Large credit stocksincrease contingentliabilities for the sovereign

Sources: DB Research, S&P's, IFS, IMF,IHS Global Insight 23




July 6, 2011 15

3.2 Baseline scenario

Macroeconomic and financial market assumptions

Before we turn to our updated public debt projections for the 17 DMsample economies, we describe our baseline scenario assumptionswith respect to the key variables that are relevant for the future

evolution of a country‟s public-debt-to-GDP ratio. As apparent fromthe right-hand side of equation (6) in Box 1 on page 13 we need tomake dynamic assumptions on a wide set of macroeconomic,financial market and fiscal indicators in order to gauge future publicdebt dynamics. In what follows, we briefly present our baselineassumptions for real GDP growth, consumer price inflation, marketinterest rates and the primary balance. Moreover, we explain howwe arrive at our nominal and real effective interest rate assumptions.

Real GDP growth (% p.a.)

For 2011-16 we take the IMF‟s real GDP growth forecasts (World

Economic Outlook Database, April 2011). For 2017-20 we assume

that our sample economies will grow at their potential, which isapproximated by the IMF‟s 2016 growth forecasts. Thus, the DMGDP-weighted real GDP growth rate is assumed to average 2.3%p.a. over the period 2011-20, somewhat higher than the 2000-09ten-year historical average (see chart 24). Average DM growth overthe next ten years is expected to be only marginally higher thanprojected in our study “Public debt in 2020: A sustainability analysisfor DM and EM economies”, published in March 2010. However, ona single country basis, 2011-20 average growth rates deviate by acouple of basis points, either positively or negatively, from previousbaseline projections (see chart 25).

At the country level, Slovakia, Sweden and Australia are expected to

post the highest average growth over the next ten years at morethan 3% per year, while Portugal and Italy are forecast to growbelow 1.5% per year, the lowest rates in our country sample. Amongthe three largest sample economies, the US economy is expected toadvance over the next ten years at a relatively robust averagegrowth rate of 2.7% per year, while real GDP growth is forecast tobe on average much weaker in Japan (+1.4% p.a.) and Germany(+1.6% p.a.) (see chart 26).

-4

-2

0

2

4

96 98 00 02 04 06 08 10 12 14 16 18 20

Baseline 2000-09 average

Sources: DB Research, IMF

Subdued growth prospectsReal GDP, % yoy(DM PPP GDP-weighted average)

24

0 1 2 3 4 5

PT

IT

JP

GR

DE

ES

CH

BE

DK

FR

CA

GB

US

IE

AU

SE

SK

DM*

Baseline assumptions ("Public debt in2020", March 2010)

New baseline assumptions

Real GDP, % yoy (2011-20 average)



Real economic growth

assumptions reviewed

25

-6

-4

-2

0

2

4

6

PT IT JP GR DE ES CH BE DK FR CA GB US IE AU SE SK DM*

Avg. 2000-09 Avg. 2011-20 2010

Real GDP


* DM PPP GDP-weighted series.

% yoy

26



Current Issues

16 July 6, 2011

Consumer price inflation (% p.a.)

In line with our real economic growth assumptions we employ thelatest IMF consumer price inflation forecasts (World EconomicOutlook Database, April 2011) for the period 2011-16. Again, for2017-20 a country‟s inflation rate is assumed to remain constant at

the IMF‟s 2016 forecast rate. Because of a moderate growth outlookthe DM GDP-weighted inflation rate is expected to average 1.8%p.a. over the next ten years (see chart 27 and 29). Inflation isprojected to be the highest in Slovakia (2.9% p.a.) and Australia(2.7% p.a.) and the lowest in Japan (0.7% p.a.).

Market interest rates (% p.a.)

We gauge a government‟s nominal market interest rate on non-inflation-linked public debt

5, i.e. its prevailing borrowing costs in

financial markets, by 10-year government bond yields. Against thebackdrop of a moderate growth and inflation outlook as well as agradual normalisation of monetary policies, the DM GDP-weightedgovernment bond yield is projected to rise modestly over the nextfew years, to 4.6% from 3.4% in 2010 (see chart 30). Greece (7%p.a.), Portugal (6.5%) and Ireland (6.2%) will face the highestgovernment bond yields over the next ten years due to high defaultrisk premia. Japan (below 1.5% p.a.) and Germany (around 4% p.a.)are expected to pay the lowest market interest rates on newgovernment debt issues, as a result of comparably low inflation and

their status of “safe havens” (see chart 28).5

Our nominal interest rate projection for inflation-linked debt is determined by ourunderlying projections for the base (i.e. “real”) interest rate component on inflation-linked debt as well as the inflation rate.

-2

-1

01

2

3

4

5

6

JP CH GR IE PT ES US FR DE DK SE IT CA BE GB AU SK DM*

Avg. 2000-09 Avg. 2011-20 2010

CPI (aop), % yoy



Inflation

27

0

2

4

6

8

10

12

14

JP DE DK SE FR US SK BE CH CA IT GB ES AU IE PT GR DM*

Avg. 2000-09 Avg. 2011-20 2010

10-year government bond yields, %



Market interest rates

28

-1

0

1

2

3

4

96 98 00 02 04 06 08 10 12 14 16 18 20



Moderate inflation outlookInflation, % (DM PPP GDP-weighted avg.)

29

2

3

4

5

6

96 98 00 02 04 06 08 10 12 14 16 18 20



Gov't bond yields to rise10-year government bond yields, %(DM PPP GDP-weighted average)

30




July 6, 2011 17

Nominal effective interest rates (% p.a.)

A government not only has outstanding debt but also continuouslyissues new debt at different maturities (short/medium vs. long-termdebt), in different currencies (domestic vs. foreign debt) and/or atdifferent types of interest-rate contracts (fixed, floating vs. inflation-linked debt). Hence, there is no single market interest rate thatrepresents a sovereign‟s ultimate borrowing costs. While sovereignbond yields reflect the current conditions at which governments areable to borrow in financial markets, the financial costs of public debt(i.e. the average nominal interest rate paid on total government debtoutstanding) is given by the nominal effective interest rate. Asexplained in Box 1 on page 11, a country‟s current nominal effectiveinterest rate depends on a host of factors. In short, it depends on thedebt structure, the prevailing market interest rates (at which agovernment is currently able to issue new debt), the inflation rate aswell as the nominal effective interest rate(s) of the previous year.The lower the average maturity of outstanding government debt andthe higher the share of floating-rate and inflation-linked debt in total

debt, the more quickly the nominal effective interest rate adjustsupwards to rising market interest rates or higher inflation.

We approximate the sample economies‟ past nominal effectiveinterest rates by the ratio of gross government debt interestpayments to the previous year‟s gross government debt stock. The

data employed for the calculation of nominal effective interest ratescomes from the OECD‟s Economic Outlook database and refer s to

the general government level.6

Nominal effective interest rateprojections for 2011-20 depend on the initial effective interest ratelevel and our market interest rate and inflation projections, as wellas a government‟s interest-cost sensivity to changing financialmarket conditions. The DM GDP-weighted nominal effective interestrate is projected to rise gradually to around 4.2% by 2020 owing tohigher market interest rates (see chart 31). While Greece, Irelandand Portugal are projected to face the highest nominal effectiveinterest rates, at 6.1%, 5.5% and 5.4% per year over the outlookperiod due to high default risk premia, respectively, Japan isestimated to effectively pay only 1.4% p.a. on its outstanding grossgovernment debt stock thanks to subdued inflation and very lowgovernment bond market yields (see chart 32).

6The only exception is Australia where gross general government interest payments(“interest expenses other than nominal superannuation”) come from the AustralianBureau of Statistics.

2

3

4

5

6

7

96 98 00 02 04 06 08 10 12 14 16 18 20

Effective rate** (baseline)

Market rate* (baseline)

Effective rate** (2000-09 average)

Market rate* (2000-09 average)

Nominal interest rate, %(DM PPP GDP-weighted average)

Sources: DB Research, OECD, IMF, IHS GlobalInsight, Australian Bureau of Statistics

* Gauged by 10-year government bond yields. ** Pastnominal effective interest rates on total public debtoutstanding were approximated by the ratio of annualgross public debt interest payments to the previousyear's gross public debt stock.

Nominal effective interestrate to rise gradually

31

0

2

4

6

8

JP SE CH DE FR DK US ES BE GB SK IT CA AU PT IE GR DM*

Avg. 2000-09** Avg. 2011-20 2010**

Sources: DB Research, OECD, IMF, IHS Global Insight, Australian Bureau of Statistics

%Nominal effective interest rate

* DM PPP GDP-weighted average. **Past nominal effective interest rates on total public debt outstanding were approximated by the ratio of annual gross publi c debt interestpayments to the previous year's gross public debt stock.

32

0

1

2

3

4

5

96 98 00 02 04 06 08 10 12 14 16 18 20


Real effective interest rate, %(DM PPP GDP-weighted average)


Real interest rate toconverge to long-term avg.

33



Current Issues

18 July 6, 2011

Real effective interest rate (% p.a.)

In our March 2010 paper, we approximated real effective interestrates by the prevailing CPI-deflated benchmark government bondyield. We now gauge real effective interest rates by the CPI-deflatednominal effective interest rates. These are the final outcome of (a)the countries‟ underlying public debt structures

7and hence their

sensivities to changing market conditions, (b) the countries‟ initial

nominal effective interest rates approximated by the OECD‟s public

debt and fiscal data, and (c) our baseline scenario projections formarket interest rates and inflation. The DM GDP-weighted realeffective interest rate, which temporarily spiked to around 3.4% in2009 because of slumping inflation rates, is projected to rise again,though only moderately, to 2.3% p.a. by 2020, from 1.2% p.a. thisyear (see chart 33 on page 17). Although the real effective interest

rate is seen to converge to its 2000-09 annual average of around2.4%, it is still projected to remain far below levels observed duringthe late 1990s. Going forward, a continuation of expansionarymonetary policies in major DMs as well as abundant global liquiditymay prevent a more pronounced increase in the DM average realeffective interest rate. At the country level, there are largedifferences as regards to real effective interest rates (see chart 34).While the 2011-20 average real effective interest rates are expectedto be highest in Greece (4.9% p.a.), Ireland (4.0% p.a.) and Portugal(3.6% p.a.), they are projected to be lowest in Japan (0.7% p.a.).

7As in Becker (2011), we make the simplifying assumption that a country‟s public

debt structure remains constant over the outlook period.

-2

0

2

4

6

8

JP SE SK DE FR DK GB BE US IT ES AU CH CA PT IE GR DM*

Avg. 2000-09 Avg. 2011-20 2010

Real effective interest rate%


Sources: DB Research, OECD, IMF, IHS Global Insight, Australian Bureau of Statistics 34

-2

0

2

4

6

8

96 98 00 02 04 06 08 10 12 14 16 18 20


Interest-rate/growth differential, pp(DM PPP GDP-weighted average)


Interest-rate/growthdifferential to remain fairlybalanced

35

-4

-2

0

2

4

6

8

SK SE JP AU US GB FR DK DE BE CA ES CH IT IE PT GR DM*

Avg. 2000-09 Avg. 2011-20 2010

Interest-rate/growth differential

Percentage points


Sources: DB Research, OECD, IMF, IHS Global Insight, Australian Bureau of Statistics 36




July 6, 2011 19

Interest-rate/growth differential (percentage points)

Generally, the interest-rate/growth differential determines theunderlying trend of a country‟s public-debt-to-GDP ratio in the eventof a balanced primary account. The primary balance is the fiscalbalance before net debt interest payments. In case of a positivedifferential (interest rates exceed growth) the public debt ratio willtrend upwards unless the government achieves sufficiently largeprimary surpluses. Likewise, a negative differential (interest ratesare lower than economic growth) the debt ratio will remain on afalling trend if the government does not run large primary deficits. Asa result of our real growth and effective interest rate assumptions,the DM GDP-weighted interest-rate/growth differential is projected tobe fairly balanced in our baseline scenario (see chart 35). At thecountry level, Greece, Portugal and Ireland are projected to face thewidest interest-rate/growth differentials of 3.3, 2.9 and 1.1 pp,respectively, while Slovakia or Sweden, for instance, will benefitfrom comparably large negative interest-rate/growth differentials(see chart 36). On the one hand, Greece, Ireland and Portugal have

to run relatively large primary surpluses to keep public debt in checkbecause of unfavourable interest-rate/growth differentials. On theother hand, Slovakia or Sweden could stabilise or lower currentpublic debt levels even when running mild primary deficits.

Primary balance (% of GDP)

The only economic variable that can be directly influenced by thegovernment, either via changes in the tax rate/base or adjustmentsin public expenditures, is the primary balance. Historical primarybalance data is taken from the OECD‟s Economic Outlook database

(No. 89, May 2011) and refers to the general government level.While most of the EMU peripheral countries are projected to

consolidate sharply over the forecast period due to persistentfinancial market pressures (see chart 38), consolidation is expectedto take place at very different speeds in major DM economies. Whilethe UK has already launched a consolidation programme and isseen to close its primary deficit by 2016, the US and Japan still lackclear consolidation plans and are expected to adjust only graduallyover time (see chart 37). As a result, the DM GDP-weighted primarydeficit will narrow from 6.6% of GDP in 2010 to 1.5% by 2016 (seechart 39). As population ageing will increasingly weigh on fiscalaccounts and make further improvements in the primary balanceharder to achieve, we assume that the DM primary balance willcontinue to post a mild deficit of 1.5% of GDP for the remainder ofthe outlook period.

-10

-8

-6

-4

-2

0

2

4

06 08 10 12 14 16 18 20

FR GB DE

JP US

Primary balance, % of GDP

Sources: DB Research, OECD

Consolidation at differentspeeds in major DMs ...

37

-30

-20

-10

0

10

06 08 10 12 14 16 18 20

ES GR IE

PT IT

Primary balance, % of GDP


... but abrupt consolidationin most EMU peripherals

38

-8

-6

-4

-2

0

2

4

96 98 00 02 04 06 08 10 12 14 16 18 20


Primary balance, % of GDP(DM PPP GDP-weighted average)

Fiscal consolidation toadvance gradually

Sources: DB Research, OECD, IMF, IHS Global

Insight 39

-10

-8

-6

-4

-2

0

2

4

JP US SK GB ES IE CA FR AU BE DE PT CH DK IT SE GR DM*

Avg. 2000-09 Avg. 2011-20 2010

Primary balance% of GDP



2010: - 30

40



Current Issues

20 July 6, 2011

The projected improvement in the DM GDP-weighted primarybalance is driven by a combination of active fiscal consolidation, asreflected by a reduction in the structural (i.e. cyclically-adjusted)primary balances, and cyclical improvements in fiscal revenues and

expenditures due to economic recovery. At the country level, Greece(2.8% of GDP), Sweden (2.2% of GDP) and Italy (1.8% of GDP) areexpected to achieve the largest average primary surpluses over thenext ten years, while Japan (-5.4% of GDP) and the US (-4.6% ofGDP) are expected to post the largest primary deficits (see chart 40on page 19). While Ireland and Greece are projected to achieve thelargest adjustments in their primary balances, Japan is expected tocut its primary deficit only marginally (see chart 41).

Public-debt-to-GDP projections

In our March 2010 paper (which was published just before theescalation of the EMU sovereign debt crisis) we found that the DM

GDP-weighted public-debt-to-GDP ratio could soar to more than130% of GDP by 2020 if policymakers failed to implement sizeableand durable near-term fiscal consolidation. Since then much hashappened. In particular, the EMU peripheral countries are facingmuch tougher economic and financial market conditions today thanone year ago and hence are forced to press ahead with fiscalconsolidation. Feeding our updated baseline assumptions into ournew debt model, we find that the DM average public-debt-to-GDPratio will continue to climb over the next ten years, to around 126%by 2020 from 103.7% in 2010. However, the increase in debt levelsover the next ten years is projected to be somewhat lower thanenvisaged in our March 2010 study (see chart 42).

This downward revision is mainly driven by three factors. First, 2010DM average growth surprised to the upside and, furthermore, themedium-term growth outlook has slightly improved compared to lastyear. Second, real effective interest rates are projected to besomewhat lower on average than assumed in our March 2010paper. Third, and most important, the fiscal outlook has brightenedin many DM economies thanks to consolidation efforts as well asstronger-than-expected economic recovery (see chart 43).Moreover, some major DM economies such as the UK, Germany,France, Japan or Italy posted lower-than-expected primary deficitsin 2010 as their economies grew more strongly than initiallyexpected. Thus, many governments can embark on fiscalconsolidation from a better starting position.

0

5

10

15

20

25

30

35

CH JP IT BE SE DE AU FR SK CA US DK ES PT GB GR IE DM*

Change in DM primary balances: 2020 vs. 2010 levelPercentage points of GDP



41

0

20

40

60

80

100

120

140

96 98 00 02 04 06 08 10 12 14 16 18 20

Baseline

Baseline (March 2010)

Gross public debt, % of GDP(DM PPP GDP-weighted average)

Public debt remains on arising trend

Sources: DB Research, OECD, IMF, IHS Global

Insight 42

-6 -4 -2 0 2 4

JP

US

SK

GB

ES

IE

CA

FRAU

BE

DE

PT

CH

DK

IT

SE

GR

DM*

Baseline assumptions ("Public debt in

2020", March 2010)

New baseline assumptions

Primary balance, % of GDP(2011-20 average)



Primary balanceassumptions reviewed

43




July 6, 2011 21

Public debt is still projected to remain on a rising trend in just overhalf of our sample economies (9 out of 17), including the US, Japan,

the UK as well as most of the crisis-hit EMU countries such asSpain, Ireland, Portugal and Greece. As regards the remaining DMsample economies, the public-debt-to-GDP ratio is expected toremain broadly unchanged in France and to decrease in Australia,Belgium, Denmark, Germany, Italy, Switzerland and Sweden (seechart 44). What are the conclusions from our updated baselinescenario analysis? Although the DM public-debt-to-GDP ratio is nowpredicted to rise at a somewhat slower pace than sketched one yearago, it is still projected to climb by more than 20% of GDP until 2020(from 2010 levels) despite the launch and implementation ofconsolidation programmes in some economies. In particular, thesharply rising US debt stock could have severe repercussions if

financial markets lost confidence in the US dollar. The recent moveby S&P‟s to attach a negative outlook to the US government‟s AAA

long-term credit rating may serve as a warning shot to the US totackle its large budget problems. Because of further rising debtlevels and higher interest rates, the DM average net debt interestburden could more than double to almost 4% of GDP in 2020 fromaround 1.8% in 2010, according to our calculations (see chart 45).Overall, DM governments will have to press ahead with even morestringent consolidation steps than assumed in our baseline scenarioto avoid an increasing debt burden.To stress the importance of near-term consolidation we project debt dynamics in a so-called no-policy-change scenario in which no active fiscal consolidation takes

place over the outlook period.

-50

0

50

100

150

200

250

SE AU CH DK SK DE ES GB BE CA FR IT IE PT US GR JP DM*

2007 debt stock Change in debt stock 2008-10 Change in debt stock 2011-20

Gross public debt, % of GDP (baseline)

*DM PPP GDP-weighted average.

Public debt in 2020: Updated baseline scenario projections

Sources: DB Research, OECD, IMF 44

-10

-8

-6

-4

-2

0

2

4

96 98 00 02 04 06 08 10 12 14 16 18 20

Net debt interest payments*

Fiscal balance

Primary balance


% of GDP, baseline scenario(DM PPP GDP-weighted average)

Debt burden to rise sharplyin baseline scenario

* Gross debt interest payments minus interest receipts.Gross debt interest payments were calculated fromour model. Interest receipts were assumed to remainconstant over time at the 2010 level of around 1% ofGDP.

45

0

50

100

150

200

250

SE AU CH DK SK DE ES GB BE CA FR IT IE PT US GR JP DM*

Current (2010) Baseline scenario (2020) No-policy-change scenario (2020)


*DM PPP GDP-weighted average.

Public debt in 2020: Baseline vs. no-policy-change scenario projections




Current Issues

22 July 6, 2011

In the no-policy-change scenario we employ the same assumptionsfor growth, inflation and interest rates as in the baseline scenario.However, no further active fiscal consolidation is presumed to takeplace over the coming years. In other words, a country‟s structural(i.e. cyclically-adjusted) primary balance is assumed to remain at its2010 level. In the absence of active fiscal consolidation the DM

GDP-weighted primary deficit is estimated to shrink only slightlyover the outlook period. The estimated reduction in the DM GDP-weighted primary deficit to slightly less than 5% of GDP by 2016from 6.6% of GDP in 2010 would be driven solely by cyclical factors(i.e. driven by an economic recovery) (see chart 47).

The message of the “no-policy-change” scenario is alarming. Ifconsolidation failed, the DM GDP-weighted public-debt-to-GDP ratiowould increase by an additional 26.9% of GDP compared with thebaseline scenario, reaching more than 150% of GDP in 2020 (seechart 48). While the public debt level would reach around 165% ofGDP in the US, it would increase to around 244% in Japan, around143% in the UK, around 123% in France and around 121% in Spain

(see chart 46 on page 21).

3.3 Shock scenarios

Shock scenario methodology

In addition to our baseline scenario we perform four adverse single-variable as well as two combined shock scenarios for the outlookperiod 2011-20 to account for renewed economic and financialturmoil. In (a) the single real economic growth shock scenario, acountry‟s real GDP growth rate is given by the baseline growthnumber minus 0.5 times the historical standard deviation. Asregards (b) the single primary balance shock scenario, agovernment‟s primary balance is given by the baseline level minus0.5 times the historical standard deviation. For both variables weuse five-year (2005-09) historical standard deviations. Contrary toBecker et al. (2010) we do not apply the standard-deviation-shockframework to market interest rates. Given that historical standarddeviations of the past couple of years were relatively low for mostDM economies, the application of the standard-deviation-shockapproach produced an interest-rate-shock scenario that would mostprobably be too benign (see chart 49). In (c) the single marketinterest rate shock scenario we therefore assume a country‟s market

interest rates to be 50% (instead of the 0.5 standard deviation)higher than in the baseline scenario.

In (d) the contingent-liability-shock scenario the underlyingmacroeconomic and financial market assumptions are the same asin the baseline scenario, but we assume contingent liabilities fromthe banking sector to materialise in 2011, thereby causing animmediate one-off increase in public debt levels. In our combinedshock scenarios the real GDP growth rate as well as the primarybalance are calculated as their baseline numbers minus 0.25 timesthe historical standard deviation, while the market interest rate isassumed to be 25% higher than in the baseline scenario. Withrespect to inflation, the medium/long-term outlook is highlyuncertain. Some economists are more concerned about medium-term deflation risks as renewed turmoil could lead to large outputgaps and deflationary tendencies, while other market observers are

more worried about the upside risks to the medium to long-terminflation outlook because of highly expansionary monetary policiesin major DM economies and rapidly rising public debt levels.

-8

-6

-4

-2

0

2

4

96 98 00 02 04 06 08 10 12 14 16 18 20

Baseline scenario

No-policy-change scenario


Primary balance, % of GDP(DM PPP GDP-weighted average)

If fiscal consolidationfails ...

47

025

50

75

100

125

150

175

96 98 00 02 04 06 08 10 12 14 16 18 20

Baseline scenario

No-policy-change scenario


... public debt could exceed150% of GDP by 2020


0

1

2

3

4

5

6

7

8

J P

D E

D K

S E

F R

U S

S K

B E

C H

C A I T

G B

E S

A U I E

P T

G R

D M *

Baseline Negative shock**

Source: DB Research

Market interest rate instandard-deviation shockapproach10-year gov't bond yields in single marketinterest rate shock, % (2011-20 avg.)

* DM PPP GDP-weighted average. **Calculated as the

baseline market interest rate plus 0.5 times the 5 -year(2005-09) standard deviation.

49




July 6, 2011 23

To account for both inflation scenarios, lower and higher inflation, wefinally perform two combined shock scenarios. In (e) the firstcombined shock scenario we assume inflation to accelerate globally.In this scenario, a country‟s inflation rate is assumed be 25% higherthan in the baseline case. In (f) the second combined shockscenario, inflation is projected to decelerate worldwide. In this

scenario, a country‟s inflation rate is presumed to be 25% lower thanin the baseline scenario

8. All shocks, apart from the contingent

liability shock (which is a “one-off” shock), are assumed to persistthroughout the whole period 2011-20, i.e. are permanent shocks.

9

Public-debt-to-GDP projections in a shock scenario

(a) Single real GDP growth shock scenario. In the singleeconomic growth shock scenario the DM GDP-weighted real GDPgrowth rate is assumed to fall permanently short of baseline growthby 1.4 percentage points over the outlook period 2011-20, to 0.9%yoy from 2.3% yoy; see chart 51). On the one hand, real GDPgrowth will be most affected in absolute terms in Ireland, Slovakia

and Sweden, according to our shock scenario framework, wheregrowth is assumed to be 3.1, 3.0 and 2.0 percentage points,respectively, below baseline numbers. On the other hand, economicgrowth will be least affected in absolute terms in Australia, Portugaland France, where growth is assumed to fall short of baselinegrowth by 0.6, 0.9 and 1.0 percentage points, respectively, (seechart 51). As regards debt projections in the single growth shock,the DM-GDP-weighted public-debt-to-GDP ratio will be around 17percentage points of GDP higher than in the baseline scenario. Atthe country level, Ireland (+46% of GDP), Japan (+42% of GDP) andGreece (+30% of GDP) will face the steepest increases in their debtratios relative to their baseline debt ratio projections. (see chart 50).

(b) Single primary balance shock scenario. In this shockscenario, the DM GDP-weighted primary balance is assumed to fall(on a 2011-20 average) by 1.7 percentage points below baselinelevels, to -4.2% of GDP from -2.6% of GDP. As regards individual

8In line with our market interest rate shock scenario assumptions, we also refrainfrom applying the the standard-deviation-shock framework to the inflation rate.

9With the exception of the market interest rate as well as the inflation rate shock

assumptions, our shock scenario framework is broadly in line with the IMF‟s ArticleIV public debt sustainability framework. The IMF assumes all variables to deviatepersistently from the baseline numbers by half a standard deviation in a single-variable-shock and by one-quarter of a standard deviation in a combined-variable-shock scenario.

1

4

7

10

11

11

12

13

14

14

15

15

16

21

30

42

46

17

0 50 100 150 200 250 300

AU

CH

SE

DK

FR

CA

BE

PT

US

ES

DE

SK

GB

IT

GR

JP

IE

DM*

Baseline Real GDP shock

Gross public debt, % of GDP (2020)



Single real GDP shock debtprojections

50

-1

0

1

2

3

4

5

P T I T

J P

G R

D E

E S

C H

B E

D K

F R

C A

G B

U S I E

A U

S E

S K

D M *

Baseline Negative shock

Real GDP growth shock assumptionsReal GDP, % yoy (2011-20 average)


Sources: DB Research, IMF 51



Current Issues

24 July 6, 2011

countries, primary balances would be most affected in absoluteterms in Ireland (-3.5 pp of GDP below baseline), Spain (-2.8 pp)and Greece (-2 pp) and least affected in Switzerland (-0.5 pp), Italy(-0.8 pp) and Germany (-0.9 pp) (see chart 53). As regards debtprojections, the DM GDP-weighted debt ratio will be around 17percentage points of GDP higher than in the baseline scenario. At

the country level, Ireland (+36% of GDP), Spain (+30% of GDP) andGreece (+23% of GDP) will see the steepest increases in their debtratios relative to their baseline debt ratio projections (see chart 52).

(c) Single market interest rate shock scenario. The nominaleffective interest rate of a government with a long average maturityand/or a high share of fixed-interest-rate debt reacts more sluggishlyto rising market interest rates than that of a sovereign with short

debt maturities and a high share of floating-interest-rate debt. Thisrelationship is now explicitly considered in our new scenario tool. Inthe market interest rate shock scenario, the DM GDP-weightedgovernment bond yield is assumed to increase (on a 2011-20average) by 2.2 percentage points above baseline levels, to 6.5%from 4.3%. At the country level, government bond yields would risemost significantly in absolute terms in Greece (3.5 pp abovebaseline levels), Portugal (3.2 pp) and Ireland (3.1 pp) and the leastJapan (0.7 pp), Germany (2.0 pp) and Denmark (2.1 pp) (see chart55). As regards debt projections, the DM GDP-weighted debt ratiowill be around 14 percentage points of GDP higher than in thebaseline scenario. At the country level, Greece (+53% of GDP),

Portugal (+27% of GDP) and Ireland (+24% of GDP) will see the

5

9

9

9

11

11

13

13

15

16

16

17

18

19

23

30

36

17

0 50 100 150 200 250 300

CH

SE

DE

IT

SK

FR

BE

AU

JP

CA

PT

GB

DK

US

GR

ES

IE

DM*

Baseline Primary balance shock




Single primary balanceshock debt projections

52

-8

-6

-4

-2

0

2

4

J P

U S

S K

G B

E S I E

C A

F R

A U

B E

D E

P T

C H

D K I T

S E

G R

D M *



Primary balance shock assumptionsPrimary balance, % of GDP (2011-20 average)


53

3

4

5

6

6

8

9

10

11

11

13

13

17

21

24

27

53

14

0 50 100 150 200 250 300

SE

AU

CH

DK

GB

SK

DE

JP

FR

ES

CA

BE

US

IT

IE

PT

GR

DM*

Baseline Market interest rate shock**



* DM PPP GDP-weighted average. **In the singlemarket interest rate shock both the nominal market

interest rate on non-inflation-linked debt (which isgauged by the 10-year government bond yield) and thebase rate (i.e. the real interest rate component) oninflation-linked debt are assumed to be higher than inthe baseline scenario.

Single market interest rateshock debt projections

54

0

2

4

6

8

10

12

J P

D E

D K

S E

F R

U S

S K

B E

C H

C A I T

G B

E S

A U I E

P T

G R

D M *



* DM PPP GDP-weighted average. **In this chart we show our nominal market interest rate assumptionsfor non-inflation-linked debt only.

Market interest rate shock assumptions10-year government bond yields**, % (2011-20 average)

55




July 6, 2011 25

steepest increases in their debt ratios relative to their baseline debtratio projections (see chart 54 on page 24).

(d) Contingent liability shock scenario. Contingent liabilities fromthe banking sector can be an important risk factor for public debtsustainability. In the event of a severe banking crisis, thegovernment may have to come to the aid of its domestic financialinstitutions and cover most of the banks‟ financial losses. This couldpush the public-debt-to-GDP ratio sharply upwards, thereby causingconcerns about public debt sustainability. The Irish sovereign debtcrisis, which was to a large extent caused by the country‟s ailing

banking sector, is only the most recent example.

In line with Becker (2011), our contingent liability calculations arebased on a country‟s 2010 year -end private-sector-credit-to-GDPratio (see chart 23 on page 14)10 and S&P‟s latest estimates for a

country‟s gross problematic assets (GPA) as a percentage of total

assets from the banking sector (see chart 57). S&P‟s estimates a

GPA range, i.e. a lower and an upper limit for the banking sector‟s GPA in percent of total assets.

11Our calculations are based on the

average of S&P‟s lower and upper limit estimates for the share of

gross problematic assets. According to our estimates, contingentliabilities from the banking sector could be largest in Ireland (81.9%of GDP), Spain (32.6% of GDP) and Portugal (32.3% of GDP) (seechart 56). As regards a shock scenario in which governments faceimmediate financial-sector bailout costs in 2011, public-debt-to-GDPratios in 2020 could climb most significantly (relative to the baseline

scenario) in Ireland (+89% of GDP), Portugal (+42% of GDP) andSpain (+35% of GDP) (see chart 58).

As a result, the DM GDP-weighted public-debt-to-GDP ratio couldrise to around 140% of GDP by 2020 and hence could be 14% ofGDP higher than predicted in our baseline scenario. However, wewould like to stress that the above contingent liability shock scenariois based on relatively rough estimates for sovereign contingent

10For some sample economies no IFS data is available on the private-sector creditstock. For these economies we used the stock of “Other sectors“, which isdomestic credit minus credit to the general government level.

11 See S&P‟s (2011), pp. 2-6. S&P‟s GPA range is an estimate of a country's potential

proportion of credit to the private sector and non-financial public enterprises that

could become problematic during a severe economic downturn. According toS&P‟s, problematic assets include overdue loans, restructured assets (where the

original terms have been altered), foreclosed real estate and other assetsrecovered in loan workouts, and non-performing assets sold to special-purposevehicles.

9.5

10.2

10.8

11.6

11.8

12.5

12.7

12.9

14.1

17.6

19.2

22.4

26.3

30.7

32.3

32.6

81.9

14.0

0 10 20 30 40 50 60 70 80 90

US

JP

SK

BE

DE

AU

CA

FR

SE

CH

IT

DK

GR

GB

PT

ES

IE

DM*

% of GDP (2010)


Contingent liabilitieslargest in Ireland

Sources: DB Research, S&P's, IFS, IMF,IHS Global Insight 56

0

5

10

15

20

25

30

3540

45

A U

B E

D K

F R

D E

J P

C H

S E

C A

E S

G B I T

U S

P T

G R

S K I E

D M *

Lower bound Mid bound Upper bound

Gross problematic asset estimates by S&P'sGross problematic assets, % of total banking sector assets (2010)


Sources: DB Research, S&P's, IMF 57

9

9

10

12

12

12

12

13

13

19

21

23

30

34

35

42

89

14

0 50 100 150 200 250 300

SK

US

JP

SE

AU

BE

DE

FR

CA

CH

IT

DK

GB

GR

ES

PT

IE

DM*

Baseline Contingent liability shock



Contingent liability shockdebt projections

Sources: DB Research, OECD, IMF, S&P's, IFS,IHS Global Insight 58



Current Issues

26 July 6, 2011

liabilities from the banking sector (which are based on IFS creditstock data and S&P‟s GPA range estimates as of April 8, 2011) andhence could either over- or underestimate contingent claims on thegovernment.

(e/f) First and second combined shock scenarios. As our

combined shock scenarios permanently affect all variables at thesame time, we assume that the real GDP growth rate and theprimary balance deviate “only” by the 0.25 standard deviation fromtheir baseline levels as higher standard deviations would most likelyproduce a too extreme shock scenario. Furthermore, we assumethat market interest rates climb “only” by 25% above baselinenumbers. In the first combined shock scenario, where consumerprice inflation is presumed to edge higher (i.e. is assumed to be25% higher than in the baseline scenario), public-debt-to-GDP ratioswill see the steepest increases relative to the baseline 2020 debtprojections in Ireland (+49% of GDP), Greece (+48% of GDP) andJapan (+29% of GDP) (see chart 59).

Our second combined shock scenario, where inflation is presumedto fall below baseline numbers (i.e. is assumed to fall 25% belowbaseline numbers), produces higher debt stock projections than ourfirst combined shock scenario as higher inflation generally helpsgovernments to lower debt-to-GDP ratios – irrespective of whether acountry has a high or a low share of inflation-linked debt (see chart60). Of course, if inflation exceeds a certain threshold and spins outof control, market interest rates may increase more thanproportionally in response, thereby strongly limiting or even invertingthe “debt-lowering” effects of inflation.

Summary of pessimistic shock scenarios

As explained in the shock scenario analysis (and depicted in charts

62 and 63 on page 27), the DM GDP-weighted public-debt-to-GDPratio could climb even more sharply in the event of renewedeconomic and/or financial market turmoil than sketched in ourbaseline scenario. Precisely, the DM GDP-weighted public-debt-to-GDP ratio could spike to more than 155% of GDP in our secondcombined shock scenario (see charts 62 and 63), which ischaracterised by permanently weaker real GDP growth (annualaverage growth of 1.6% during the outlook period 2011-20 vs. 2.3%in the baseline scenario), lower consumer price inflation (1.3% yoyvs. 1.8% yoy), higher market interest rates (5.4% vs. 4.3%) and awider primary deficit (-3.4% of GDP vs. -2.6% of GDP). The

6

8

8

12

1213

14

14

15

16

19

20

22

24

29

48

49

19

0 50 100 150 200 250 300

CH

AU

SE

DE

FR

SK

BE

DK

CA

GB

IT

US

PT

ES

JP

GR

IE

DM*

Baseline First combined shock




First combined shock debtprojections

59

8

11

11

21

21

21

21

25

26

26

32

33

33

36

38

61

61

30

0 50 100 150 200 250 300

CH

SE

AU

DK

DE

FR

SK

GB

BE

CA

US

ES

IT

PT

JP

GR

IE

DM*

Baseline Second combined shock




Second combined shockdebt projections

60

2.3

-2.6

4.3

1.8 1.80.9

-4.2

6.5

1.6

-3.4

5.4

2.21.3

-6

-4

-2

0

2

4

6

8

Real GDP,% yoy

Primarybalance,

% of GDP

Marketinterest rate*,

%

Inflation rate,% yoy

(First comb.shock)

Inflation rate,% yoy

(Second comb.shock)

Baseline Single shock Combined shocks

Baseline vs. shock scenario assumptionsPessimistic shocks, 2011-20 average (DM PPP GDP-weighted average)

* on non-inflation-linked debt. The market interest rate on non-inflation-linked debt is gaugedby the 10-year government bond yield.





July 6, 2011 27

underlying assumptions for all single and combined shock scenariosare summarised in chart 61 on page 26. However, in our firstcombined shock scenario, in which the inflation rate is assumed tostay above its baseline figures (2.2% yoy vs. 1.8% yoy in thebaseline scenario), the public-debt-to-GDP ratio would climb lesssharply to around 145% of GDP. As regards the single shock

scenarios, the DM GDP-weighted public-debt-to-GDP ratio wouldreach the highest levels in the growth shock by the year 2020 (seechart 62).

Optimistic shock scenarios

Finally, we are interested in what could happen to debt dynamics inthe event of more favourable financial and economic conditions thanassumed in the baseline scenario. When running our single andcombined shocks with opposite signs (i.e. assuming higher insteadof lower growth, stronger instead of weaker primary balances, lowerinstead of higher market interest rates, and so forth), the DM GDP-weighted public-debt-to-GDP ratio would only come back over time

on a moderate downward trend in the optimistic second combinedshock scenario. In the remaining optimistic shock scenarios, such asthe first combined shock scenario or the single growth shock, theDM GDP-weighted public-debt-to-GDP ratio would only stabiliseover time at very high debt levels of around 110% of GDP (see chart64).

As regards the optimistic second combined shock scenario, thepublic-debt-to-GDP ratio would still remain at very high levels ofmore than 90% of GDP in a couple of smaller as well as major DMeconomies, including the US, Italy, Portugal, Greece and Japan (seethe blue bars in chart 65). Interestingly, only in the US and Japanpublic-debt-to-GDP ratios would continue to climb from current

(2010) debt levels in the optimistic second combined shock scenario(compare the blue bars with the dark lines in chart 65), showing thatcurrent fiscal policies would still produce higher debt stocks in theevent of more favourable marcoeconomic and financial marketconditions. Overall, the optimistic shock scenario exerciseunderlines that many DM countries have to do more than just returnto “business as usual” in order to restore/ensure long-term publicdebt sustainability.

60

80

100120

140

160

2 0 0 7

2 0 1 0

B a s e

l i n e

C o n

t . l i a b i l i t y

I n t e r e s

t r a

t e

P r i m a r y

b a

l a n c e

G r o w

t h

F i r s t c o m

b .

S e c o n

d c o m

b .


Pessimistic shock scenariodebt projections (2020)

Sources: DB Research, OECD, IMF, IFS, S&P's,IHS Global Insight 62

90

100

110

120

130

140

150

160

10 11 12 13 14 15 16 17 18 19 20

BaselineReal GDP shock

Primary balance shock

Interest rate shock

First combined shock

Second combined shock

Contingent liability shock


Pessimistic shockscenarios in comparison


90

100

110

120

130

140

150

160

10 11 12 13 14 15 16 17 18 19 20

Baseline

Real GDP shock

Primary balance shock

Interest rate shockFirst combined shock

Second combined shock


Optimistic shock scenariosin comparison


0

50

100

150

200

250

300

S E

A U

C H

D K

S K

D E

E S

G B

B E

C A

F R I T I E

P T

U S

G R

J P

D M *

Positive shock Baseline Negative shock Current (2010)


Second combined shock scenario: Gross public debt, % of GDP (2020)

DM public debt would remain broadly unchanged inan optimistic scenario




Current Issues

28 July 6, 2011

Box 2: Calculating fiscal consolidation needs

For both investors and governments it is important to know the magnitude of future fiscal consolidation needsin order to stabilise or reduce the public-debt-to-GDP ratio to certain target debt levels. The followingcalculation of fiscal consolidation needs is borrowed from Sturzenegger (2002) and Ley (2005).

Stabilising the public-debt-to-GDP ratio at the current (2010) level

The required primary balance to stabilise the public-debt-to-GDP ratio, denoted as pb , is given by:

)7(1

0d g

gr pb

where r denotes a government„s real effective interest rate, g the real GDP growth rate and0

d theprevailing public-debt-to-GDP ratio.

As can be seen from the right-hand side of equation (7), the required primary balance to stabilise the currentpublic-debt-to-GDP ratio is determined by the real-interest-rate/real-GDP-growth differential as well as theprevailing debt level. While governments which are confronted with a positive real-interest-rate/real-GDP-growth differential (i.e. with a real interest rate that exceeds the real GDP growth rate) need to achieve aprimary surplus to stabilise the prevailing public-debt-to-GDP ratio, governments facing a negative real-interest-rate/real-GDP-growth differential (i.e. with a real interest rate that falls short of the real GDP growthrate) could run primary deficits to stabilise the current public-debt-to-GDP ratio. Generally, the wider a country‟s

positive (negative) real-interest-rate/real-GDP-growth differential, the larger the government‟s required primary

surplus (primary deficit) to stabilise the current public-debt-to-GDP ratio.

Lowering the public-debt-to-GDP ratio to target debt levels

The required primary balance to lower the current public-debt-to-GDP ratio to a target debt level is given by:

)8(

1

1

1

1

1

0

*

0

*

T

j

j

T

g

r

d g

r d

pb

where* pb denotes the primary balance that needs to be achieved by the government to lower the current

public-debt-to-GDP ratio to a target debt level of*

d over the next T years.

As can be seen from the right-hand side of equation (8), the required primary balance is determined by thereal-interest-rate/real-GDP-growth differential, the prevailing and target debt levels as well as the time horizonfor debt reduction. Generally, the lower the target debt level and the shorter the time horizon during which debtreduction should take place, the larger the required primary balance to lower the public-debt-to-GDP ratio.Countries with a high public-debt-to-GDP ratio and wide (positive) real-interest-rate/real-GDP-growthdifferentials need to run large primary surpluses to lower their debt levels.




July 6, 2011 29

4. Fiscal consolidation needs

It is essential to know how much fiscal adjustment is needed to bringpublic finances back on a sound(er) footing. Obviously, thedimension of and the time frame for fiscal consolidation differ widelyacross countries and depend on the economic and financialconditions which governments face (i.e. economic growth andeffective interest rates on outstanding government debt), the currentstance of fiscal policy (i.e. large, medium or smalldeficits/surpluses), the prevailing debt level (i.e. low, medium or highgovernment debt) as well as the desired target debt level. Whilehighly indebted sovereigns will be forced to lower their debt ratiossignificantly, governments with already low or only moderate debtlevels may only have to stabilise their debt ratios to ensure long-term debt sustainability.

In this chapter we want to answer three questions:

First, how much fiscal adjustment is needed to stabilise the public-

debt-to-GDP ratio at the current (2010) level.Second, given that the recent rise in public debt was mainly drivenby the global financial crisis, how large is the fiscal adjustment tobring the debt ratio back to its pre-crisis (2007) level.

Third, how much fiscal adjustment is needed to lower the debt stockto so-called “prudent” benchmark debt levels such as the 60%-of-GDP Maastricht criterion.

The methodology to calculate fiscal consolidation needs is explainedin Box 2 on page 28.

4.1 Stabilising debt ratios at 2010 levels

Some sample economies (such as Japan, Sweden or Slovakia) canrun mild primary deficits to stabilise their public-debt-to-GDP ratiosat current levels thanks to favourable interest-rate-/growthdifferentials (see chart 66). At the same time, Greece, Portugal, Italyand Ireland need to run comparatively large primary surpluses ofbetween 1.2% of GDP (in the case of Italy and Ireland) and around4.9% of GDP (in the case of Greece) because of relatively high debtlevels and unfavourable interest-rate/growth differentials (see chart66). However, in order to see how close a government ‟s current

fiscal policy stance is to debt stabilisation, we compare a country‟s

required debt-stabilising primary balance (in the followingabbreviated by RPB) with its current primary balance andalternatively with the achieved average primary balance during the

last business cycle.

-2 -1 0 1 2 3 4 5

JP

SK

SE

US

GB

FR

AU

DK

DE

BE

CH

CA

ES

IE

IT

PT

GR

DM**


* Calculations are based on 2011-20 averageprojections for real GDP growth and the real effectiveinterest rate. ** DM PPP GDP-weighted average.

Ireland & Southern Europeneed the largest primarysurpluses to stabilise debt

RPB to stabilise the gross debt ratio atthe 2010 level*, % of GDP

66

-10

-8

-6

-4

-2

0

2

4

6

JP SK SE US GB FR AU DK DE BE CH CA ES IE IT PT GR DM**

Primary balance (avg. 2005-09) Primary balance (2011) Required primary balance* (baseline)


% of GDP

*Required primary balance to stabilise the gross public-debt-to-GDP ratio at 2010 level. Calculations are based on 2011-20 average projections for real GDP growth and the realeffective interest rate. ** DM PPP GDP-weighted average.

Greece, Portugal and Ireland have to achieve large primary surpluses to stabilise debt

67



Current Issues

30 July 6, 2011

In the following we compare a country‟s estimated primary balancefor this year (i.e. 2011) with its RPB as well as with its historical

(2005-09) average primary balance. Three out of the four sampleeconomies with the largest RPB are currently nowhere near debtstabilisation, according to our calculations (see chart 69). While, forinstance, the Greek primary balance is estimated to post a deficit ofaround 2% of GDP in 2011 (vs. an estimated RPB of 4.9%), the Irishprimary balance is expected to record a deficit of 7.1% of GDP thisyear (vs. a RPB of 1.2%). In Italy, where the government is expectedto achieve a primary surplus of around 0.5% of GDP this year (vs. aRPB of 1.2% of GDP), near-term debt stabilisation is not out ofsight. As regards the whole DM country sample, the current primarygap

12to reach near-term debt stabilisation (as measured by the gap

between a country‟s RPB and its 2011 primary balance estimate) is

currently the largest in Ireland (~8.3% of GDP) and in the US(~7.7%) followed by Greece (~6.8%), Japan (~5.9%), the UK(~5.8%) and Spain (~5.1%) (see charts 67 and 69).

Moreover, even when assuming more favourable economic andfinancial market conditions (i.e. higher growth, lower interest rates,etc.) most of the above countries would still record large primarygaps and thus would be nowhere near short-term debt stabilisation(see the black lines in chart 68). Not surprisingly, many more samplecountries would post large primary gaps in the event of moreadverse economic and financial market conditions (i.e. lower growth,higher interest rates, etc.) (see the grey lines in chart 68). Overall,

12The primary gap indicator is based on the ideas of Blanchard (1990).

-4

-2

0

2

4

6

8

10

DK SE BE CH DE AU CA IT FR ES SK JP GB US IE PT GR DM**


Primary gap vs. 2005-09 avg. primary balance*, percentage points of GDP

* The primary gap indicator is defined as the required primary balance to stabilise the gross public-debt-to-GDP ratio at 2010 level minus the average primary balance during2005-09. ** DM PPP GDP-weighted average.

Return to "business as usual" will not suffice for debt stabilisation in many countries

70

-4

-2

0

2

4

6

8

10

12

SE CH DE BE IT AU FR DK SK CA PT ES GB JP GR US IE DM**

Baseline scenario Pessimistic second combined shock scenario Optimistic second combined shock scenario


Primary gap vs. 2011 primary balance*, percentage points of GDP

* The primary gap indicator is defined as the required primary balance to stabilise the gross public-debt-to-GDP ratio at 2010 level minus the projected primary balancefor 2011. ** DM PPP GDP-weighted average.

Ireland, the US and Greece face the largest consolidation needs to stabilise debt

68

-4 -2 0 2 4 6 8 10

SE

CH

DE

BE

IT

AU

FR

DK

SK

CA

PT

ES

GB

JP

GR

US

IE

DM**


Primary gap vs. 2011 primary balance*,percentage points of GDP

* The primary gap indicator is defined as the requiredprimary balance to stabilise the gross public-debt-to-GDP ratio at 2010 level minus the projected primarybalance for 2011. ** DM PPP GDP-weighted average.

Widest primary gaps inIreland, the US and Greece

69




July 6, 2011 31

the above analysis shows that most DM sample economies, apartfrom a few exceptions like Sweden, Switzerland, Germany, Belgium,Italy or Australia, are still far away from near-term debt stabilisation.Moreover, in many economies (such as Greece, Portugal, Ireland,the US, the UK, Japan, Slovakia, Spain and France) fiscalpolicymakers will have to do more than just return to “business as

usual” in order to stabilise debt ratios.

In other words, fiscal policymakers in those countries will have to domore than merely adjust the primary balance back to historicalaverages (such as the five-year 2005-09 average) in order toachieve near-term debt stabilisation. On the other hand, there aresome countries (such as Denmark, Sweden, Belgium, Switzerland,Germany, Australia, Canada and Italy) where “business as usual” could suffice for debt stabilisation (or in some cases, even suffice fordebt reduction) (see chart 70 on page 30). As the rapid increase inpublic indebtedness over the past few years has been driven mainlyby the global financial crisis, we now estimate a country‟s fiscalconsolidation requirements to lower debt ratios to pre-crisis levels.

4.2 Lowering debt ratios to pre-crisis levels

In most DM economies the financial crisis has caused a largeincrease in the public-debt-to-GDP ratio. The increase in the debtstock was driven either by the materialisation of contingent liablitiesfrom the banking sector (direct costs of the financial crisis for thesovereign) and/or slumping tax revenue as well as risingexpenditure (indirect costs) because of large output losses. Whilepublic debt ratios have climbed noticeably since 2007 in Ireland(+74% of GDP), the UK (+35% of GDP), Greece (+34% of GDP),Japan (+33% of GDP) or the US (+32% of GDP), they have risenless strongly in Australia (+11% of GDP) or Slovakia (+12% of GDP).

There is only one country in our DM sample, namely Switzerland,where the public debt ratio has decreased over the past three yearsby almost 7 percentage points of GDP, to just above 40% of GDP in2010 from around 47% of GDP in 2007. Moreover, there is only onesample economy (Sweden), where the public-debt-to-GDP ratio hasremained broadly unchanged (see chart 71).

In order to undo the damage caused by the global crisis over areasonably short period of time, let‟s say the next five (ten) years,i.e. in order to lower the public-debt-to-GDP ratio to pre-crisis (2007)levels by the year 2015 (2020), Ireland, Greece and Portugal wouldhave to achieve extremely large primary surpluses of an estimated16.3% (8.5%) of GDP, 12.2% (8.8%) of GDP, and 8.8% (6.0%) of

GDP, respectively (see the blue and grey bars in chart 72 on page32). Against the backdrop of still wide primary deficits, these threeEMU peripheral countries will most likely not be able to lower theirdebt-to-GDP ratios to pre-crisis levels over a reasonably shortperiod of time. Hence, debt reduction to pre-crisis levels wouldrealistically take relatively long in these economies and will mostlikely not be achieved within one decade. Hence, debt reduction topre-crisis levels would be a challenging process which requiresstrong political support for drastic and ongoing fiscal consolidationover more than one decade. However, debt reduction to pre-crisislevels over the next five or ten years also appears to be verydemanding, if not impossible, in most other sample economies (seechart 72).

-7

0

11

12

13

14

18

21

22

22

24

28

32

33

34

35

74

-10 0 10 20 30 40 50 60 70 80

CH

SE

AU

SK

BE

IT

CA

DK

DE

FR

ES

PT

US

JP

GR

GB

IE


Change in the gross public-debt-to-GDPratio (2010 vs. 2007 level), pp of GDP

Public debt ratios haveclimbed sharply since 2007

71



Current Issues

32 July 6, 2011

4.3 Lowering debt ratios to prudential benchmarks

Even before the global financial crisis there were only eight out of 17

sample economies with public-debt-to-GDP ratios of below 60% ofGDP, which is often considered to be a prudent benchmark debtlevel for DM economies. In 2010, only five sample economies(Australia, Switzerland, Slovakia, Sweden, Denmark) had public-debt-to-GDP ratios of below 60% (see chart 73). Moreover, publicdebt ratios are significantly above the 60% threshold in manyeconomies, including many EMU countries (e.g. Greece, Italy,Portugal, Ireland, Belgium, France and Germany) and other majorDM economies (e.g. Japan, the US, Canada and the UK). At themoment, Slovakia is the only EMU country in our DM sample whichhas a public-debt-to-GDP ratio of below the 60% and thus incompliance with the Maastricht debt criterion (see chart 73).

Most of those sample economies with government debt ratios above60% of GDP would have to implement harsh and prolonged fiscalconsolidation programmes to reduce their (2010) debt ratios to 60%of GDP over the next ten years (see the blue bars in chart 74). Onthe one hand, for instance, Greece (14.0% of GDP), Japan (12.7%),Italy (7.9%) and Portugal (7.5%) would have to run extremely largepermanent primary surpluses to lower the gross public debt level to60% of GDP by the year 2020 because of very high current debtratios and/or unfavourable interest-rate/growth differentials. On theother hand, Spain (1.1% of GDP), the UK (2.0%), Germany (2.7%)or Canada (2.8%) would have to achieve the lowest permanentannual primary surpluses to bring their public debt stocks to 60% ofGDP over the next ten years.

0 30 60 90 120 150 180 210

AU

CH

SK

SE

DK

ES

GB

CA

DE

US

FR

BE

IE

PT

IT

GR

JP

2010 2007



Public debt is significantlyhigher than 60% of GDPin most economies

73

-10

-5

0

5

10

15

20

25

30

AU SK SE CH DK ES GB DE CA US FR BE IE PT IT JP GR

in ten years (by 2020) in five years (by 2015) Primary balance (2011)

Permanently required primary balance to reach 60% of GDP target (for the gross public debt stock), % of GDPDebt reduction to prudent benchmarks is currently not within reach for most countries

The blue bar shows the required primary balance to lower the debt level over the 10-year period. The sum of the blue and grey bars shows the required primary balance to lower the debt level over the 5-year period.


-10

-5

0

5

10

15

20

SE CH SK AU BE JP FR DK CA DE IT US ES GB PT IE GR

in ten years (by 2020) in five years (by 2015) Primary balance (2011)

Permanently required primary balance to reach 2007 gross public debt level, % of GDP


The blue bar shows the required primary balance to lower the debt level over the 10-year period. The sum of the blue and grey bars shows the required primary balance to lower the debt level over the 5-year period.

Debt reduction to pre-crisis levels looks extremely demanding for most economies

72




July 6, 2011 33

However, to obtain an idea how challenging debt reduction toprudential benchmarks would be over the next ten years, wecalculate the current gap between a country‟s permanently requiredprimary balance to lower the debt level to 60% of GDP and itsestimated primary balance for this year. Our calculations show thatsuch a goal would be extremely demanding, if not impossible, for

many countries (see chart 75). Japan, for example, would have toachieve a permanent adjustment in its primary balance of around20% of GDP in order to lower its debt level to 60% of GDP by 2020.But also many other sample economies (Greece, Ireland, the US,Portugal, the UK, Italy, Canada, France, Spain and Belgium) wouldhave to achieve large permanent adjustments in their primarybalances to reach debt reduction to prudent benchmarks by 2020,ranging from around 4.5% to more than 15% of GDP. Among majorDM countries with debt levels above 60% of GDP, Germany wouldhave to achieve the smallest adjustment in its primary balance (ofaround 2.7% of GDP) to reach debt reduction to prudentbenchmarks over the next ten years. Overall, the above analysis

suggests that debt reduction to prudent benchmark levels wouldtake a very long time and require strong political will.

5. Summary and conclusions

The global crisis has caused massive fiscal deterioration andresulted in a sharp increase in public indebtedness. On a GDP-weighted average, the DM public-debt-to-GDP ratio climbeddrastically from around 77% in 2007 to roughly 104% in 2010,marking an increase of more than 25% in just three years. Publicfinances have not only become unsustainable in EMU peripheralcountries but also in some major DM economies like the US. In2010, for instance, the US fiscal balance posted an extremely largedeficit of more than 10% of GDP for the second consecutive yearand the public debt stock is estimated to reach 100% of GDP by theend of this year. Because of a still fragile economic and financialsystem, many DM policymakers face the balancing act ofsignificantly consolidating fiscal accounts without stalling economicgrowth. While the crisis-troubled EMU peripheral countries havebeen tremendously pressured by markets to consolidate drastically,other major DM economies with larger fiscal scope, including the USand Japan, have remained on a highly expansionary fiscal policypath to bolster economic growth despite rapidly rising debt levels.

According to our baseline scenario projections in chapter 3, which

are on average based on a gradual tightening of fiscal policies in theadvanced world, the DM GDP-weighted public-debt-to-GDP ratiocould continue to rise over the next ten years, to around 126% ofGDP in 2020 from around 104% today. However, should fiscalconsolidation fail, the DM GDP-weighted public debt stock couldeven soar to more than 150% of GDP by 2020, according to our no-policy-change scenario projections. Also in the event of lower-than-expected growth or higher-than-expected interest rates, public debtratios could rise much more sharply than projected in our baselinescenario. In our second combined shock scenario, for instance, theDM GDP-weighted public-debt-to-GDP ratio could surge to morethan 155% of GDP by 2020, even when assuming a gradual

withdrawal of expansionary fiscal policies. Moreover, even in anoptimistic scenario – driven by higher growth, stronger-than-expected public finances, lower interest rates and higher inflation – the DM average public-debt-to-GDP ratio would only fall very

-5 0 5 10 15 20

SE

CH

AUSK

DK

DE

BE

ES

FR

CA

IT

GB

PT

US

IE

GR

JP

Permanent fiscal adjustment*, % of GDP

Difference between required primary balance toreach the 60% of GDP target (for the gross public debtstock) over the next ten years and the estimatedprimary balance for 2011.

Debt reduction to 60% of GDP would be a long-termtask for most countries


0

20

40

60

80

100

120

140160

180

96 98 00 02 04 06 08 10 12 14 16 18 20

PT IT IE

GR ES


Public debt dynamics inEMU peripheral countries


0

50

100

150

200

250

96 98 00 02 04 06 08 10 12 14 16 18 20US JP DE

FR GB

Public debt dynamics inmajor advanced economies



77



Current Issues

34 July 6, 2011

gradually over time and still stand at around 100% of GDP by theend of 2020. All in all, our public debt sustainability scenario analysisconfirms that current fiscal policies are unsustainable in many DMeconomies. At the country level, most EMU peripherals (Ireland,Portugal, Spain and Greece) are likely to see their debt levels climbfurther despite harsh austerity measures. In the case of Greece, the

debt stock could continue to climb to around 174% of GDP by 2020and then stabilise. (see chart 76 on page 33). While the public-debt-to-GDP ratio could rise further in some major DMs like the US,Japan, Canada or the UK, it is projected to remain broadlyunchanged in France (see charts 76, 77 and 79). Last but not least,public debt levels could fall in Germany and Italy as well as in someother countries (Sweden, Denmark, Switzerland, Belgium andAustralia), according to our baseline projections (see chart 79).

In light of rapidly rising debt levels and a challenging fiscal outlookdue to population ageing, many DM governments have to continue(or start, if not yet done) consolidating their government budgets toregain/ensure fiscal credibility and long-term debt sustainability. Onaverage, DM fiscal policies are at the moment far away from near-term debt stabilisation, according to our analysis in chapter 4.Lowering debt ratios to pre-crisis (2007) or prudent benchmarklevels will require a long consolidation process and thus strongpolitical support and stamina to ultimately reach this goal. Apart fromthe EMU peripheral countries, where public debt ratios couldcontinue to rise due to unfavourable interest-rate/growthdifferentials, the US debt outlook remains particularily worrying. IfUS fiscal policymakers fail to agree on a more drastic consolidationprogramme over the next few years than presumed in our baselinescenario, the US government debt stock could soar to around 134%of GDP by 2020, sharply up from 93.6% in 2010 and 62% in 2007.As a result, the US net debt interest burden – an important indicatoreyed by external rating agencies – could rise considerably over timeand hence increasingly weigh on sovereign creditworthiness (seecharts 78 and 80). S&P‟s recent move to attach a negative outlook

to the US government‟s AAA long-term credit rating could serve as awarning shot to fiscal policymakers to prevent this scenario frommaterialising.

Sebastian Becker (+49 69 910-30664, [email protected])

Wolf von Rotberg (+49 69 910-31886, [email protected])

0 2 4 6 8 10 12

SE

DK

CHCA

AU

SK

JP

DE

ES

FR

GB

BE

US

IT

IE

PT

GR

DM**

Avg. 2005-09 2010 2020***


Net debt interest payments*, % of GDP(baseline scenario)

* Gross debt interest payments minus interestreceipts. ** DM PPP GDP-weighted average.*** Gross debt interest payments in 2020 werecalculated from our model. Interest receipts wereassumed to remain constant over time at the 2010level.

Debt burden could risesharply until 2020 ...

78-40

-30

-20

-10

0

10

20

30

4050

SEDKCHDEBEITAUFRSKGBCAESPTIEGRJPUS

Public debt dynamicsGross public debt: 2020 vs. 2010, percentage points of GDP


0 5 10 15 20 25

SE

DK

CH

CA

AU

SK

DE

JP

FR

BE

GB

ES

IT

IE

US

PT

GR

DM**

Avg. 2005-09 2010 2020***


Net debt interest payments*, % totalrevenue (baseline scenario)

* Gross debt interest payments minus interestreceipts. ** DM PPP GDP-weighted average.*** Gross debt interest payments in 2020 werecalculated from our model. Interest receipts were

assumed to remain constant over time at the 2010level. Moreover, we implicitly assumed that theprojected change in a country's primary balance overthe outlook period 2011-20 will be equally driven byadjustments in primary expenditures and totalrevenues.

... and consume a larger share of public revenue

80

mailto:[email protected]

mailto:[email protected]




July 6, 2011 35

Literature

Anderson, Jeffrey and Jared Bebee (2011). Government Debt ByCreditor: Greece, Ireland and Portugal. IIF Research Note.Institute Of International Finance.

Becker, Sebastian, Gunter Deuber and Sandra Stankiewicz (2010).Public debt in 2020: A sustainability analysis for DM and EMeconomies. Current Issues. Deutsche Bank Research.

Becker, Sebastian (2011). Public debt in 2020: Structure matters! Anew scenario tool applied to Latin America. Current Issues.Deutsche Bank Research.

Blanchard, O. J. (1990). Suggestions for a New Set of FiscalIndicators. OECD Economics Department Working Papers, No.79, OECD Publishing. http://dx.doi.org/10.1787/435618162862

Blommestein, Hans J. (2011). Public Debt Management andSovereign Risk during the Worst Financial Crisis on Record:Experiences and Lessons from the OECD Area. Sovereign Debtand the Financial Crisis. The World Bank.

De Broeck, Mark and Anastasia Guscina (2011). Government DebtIssuance in the Euro Area: The Impact of the Financial Crisis.IMF Working Paper WP/11/21.

Fitch (2010). Just How Indebted Is the JapaneseGovernment?

Ley, Eduardo (2005). Fiscal (and external) sustainability. FiscalAffairs Department, IMF.

Standard & Poor‟s, (2011). Banking Industry Country RiskAssessments.

Sturzenegger, Federico (2002). Toolkit for the Analysis of DebtProblems. Universidad Torcuato Di Tella.

http://dx.doi.org/10.1787/435618162862

http://dx.doi.org/10.1787/435618162862

http://dx.doi.org/10.1787/435618162862

http://dx.doi.org/10.1787/435618162862



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© Copyright 2011. Deutsche Bank AG, DB Research, 60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite “Deutsche BankResearch”. The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which donot necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differfrom views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes onlyand without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of theinformation given or the assessments made.In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht.

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