The Yield Conundrum
I have been going on and on about Morocco’s public debt for quite some time, and I must confess some degree of bad faith in all devoted blogposts. And then, as usual, twitter-conversations have guided my interest; Nadia Lmlili and Ahmed Benchemsi kindly suggested to devote a simple piece about the public debt, and esteemed fellow blogger, Anas Filali and I clashed over the impact of public debt on households, more specifically on the younger generation: he argued inflation and uncertainty need to be accounted for, I fired back it was a blatant sign of economic illiteracy to suggest so, since interest rates already bear that (coming from an assumed PhD candidate, and an MBA graduate, it is rather hilarious)
@moorishwanderer à part mon doctorat de médecine je n ai jamais pu faire ni la soutenance pour mon phd ni même mon mba.
— أنس الفيلالي Anas(@bigbrother_ma) November 13, 2011
I have now the opportunity to address both issues; please bear with me on some details because it may get technical at points, nonetheless, I shall do my best to bring simplicity to bear.
The yield on public debt is in simple terms the interest paid on the bonds issued by the treasury. Governments everywhere do not fund themselves exclusively with taxes and other duties paid for by taxpayers; they also borrow money, with different maturities: sometimes, ministerial departments need money to pay for routine expenses, such as paywage; when long-term investments are carried out, adequate financing sources are sought. Is it a good or a bad thing? Economists do not always agree on the subject, but there is good evidence to suggest public debt is actually a net wealth; As far as Morocco is concerned, what I find backs the idea that government intervention (through taxation and borrowing) tends to affect favourably investment fluctuation (that is, the mere existence of government expenditure/taxation brings investment volatility to significantly lower levels). Let us therefore posit from now on public debt is, in principle, a good thing. What might then be argued is: “how much public debt is good a thing?”. For emerging economies, the figure of Public Debt/GDP ratio of 60% is considered to be acceptable; for a small, outward-oriented economy that is Morocco, debt, foreign or domestic, cannot be indefinite, and thus the proposed threshold is a good benchmark.
I would argue the public and the mainstream journalists do not bother with such indicators. I mean, from what I read in the newspapers, economic-oriented pieces are either literary comments of official documents, or usually inaccurate interpretations of these figures.the recent PLL deal with the IMF, as well as the eminent new bond issue for 1Bn dollars pushed public finances and debt front and centre. Unfortunately, journalists and bloggers alike were too quick to summon the painful memories of the 1980-era of structural adjustments and hardcore austerity. I wish my voice would carry more weight and say: stop the frenzy, we are not there yet, and the road is long enough to adjust with moderate austerity costs.
I said I was implicitly telling half-truths about the debt in Morocco because I focused only on absolute values, namely the debt stock and annual PSBR (Public Service Borrowing Requirements) and I was too quick to forget the useful teachings of E. Fama and the general equilibrium models. My primary mistake was not to look closely at interest rates paid on these borrowings and the piled debt. In my defence, theses figures are not easy to come by, and their span in time is limited to the 1990s, so I shall make due with what is available – namely the synthetic yield per maturity listed on Bank Al Maghrib website.
Let me describe what I want to do by first describing the Fama-Arrow-Debreu theory applied to interest rates: these are supposed to embed every kind of information pertaining to its class asset; the yield on public debt is supposed to signal, among others, the robustness of Morocco’s public finances, the expected return from the projects the money is spent on, the credibility of the treasury to pay back the debt when it matures, and expected inflation when such time arises. In my argument therefore, I assume the interest rate to be a perfect signal, in what is called the Weak form of Market Equilibrium; weak because it assumes no unforeseen events, and all available information is already taken into account. For those interested in reading about the theoretical argument, you can read this great paper by Fama.
We now proceed with the basic idea in this blogpost: the monthly variations in estimated yields of various maturities reflect agent anticipation of risk and (potential) default; high yields do not mean intrinsic returns increased; in fact, long term interest rates remain very stable, but the risk premium varies following agents risk aversion vis-a-vis sovereign debt. Risk premium is exactly what we are talking about, as this captures all elements mentioned above many agents take into account when they go on the market and buy treasury bonds. That risk premium is difficult to assess, as far as the simple method to determine the yield curve goes – it can be deduced from empirical data, the difficult resides in assigning the proper model specification to it.
Consider two maturities of 1 year and 5 years. On May 2001, their respective yields were 4.99% and 5.84%. You immediately notice the significant difference in yields, with the longer maturity paying off higher interest, precisely because the uncertainty attached to it is higher. After all, it is easier to forecast the state of government finances in the next two years than it is in the next 5 years. Also, inflation expectations are higher because prices will rise anyway.
We could also link both maturities as follows:
this method, when applied to the example at hand, results are remarkably close:
| 1Y | 2Y | ---------------+------ Actual |4.99%|5.22%| ---------------+------ Synthetic|5.03%|5.06%| ----------------------
The differences should not arise, since rational investors are basically indifferent between 1-year and 5-years bonds. But, in real life, these investors have certain preferences (the so-called market segmentation theory) and from this simple example, it is obvious in May 2001, investors preferred more liquid debt -that is, short term 1 year yield, hence the lower yield. Conversely, these investors require a higher yield for 5-years bonds because of their preference for immediate liquidity. This is a great example to describe risk aversion.
The dearth in data on standard maturities (say from 1 to 15 years) is a blessing in disguise, because it allows for a practical application of the fancy fairy theory to hard stock reality. As usual, results are ambiguous; we observe indeed the same phenomena described above occurs from time to time, with significant spreads with respect to close levels. For instance, much of 1995 gainsays this because theoretical levels are much lower (with differences as high as 2 percentage points) than those observed for available months. The 10-year bond required a yield of 10% in September 1995 (remember those were the days of post-PAS, fiscal consolidation and low growth) even though theoretical yields computed on the basis of 1-year debt, closer to 8.3%. Why so? As mentioned before, Moroccan investors are quite risk averse, and prefer to invest in more liquid debt, in this case, debt with maturities shorter than 1 year.
Still and all, the constant fiscal conservatism observed over the past 20 years brought all yields down to historically low levels: my preferred benchmark, the 10-year bond yield, was cut down from almost 10.5% early 1995, to a little under 4.5% in 2012, that’s almost 2Bn dirhams saved on interest over the last 5 years. This is also true for other maturities (as shown on the graph); similar levels of high interest rates were observed during the 1980s, close to 8% for prime rates. This is why I do not share the alarmist reports on a new “PAS”: we are not nearly as bankrupt as we were back in the 1980s, inflation is not nearly half that of the past period, and domestic, let alone foreign debt is way below 1980s levels. That is why I confess my failure to report on that bit of news: compared to the 1980s and 1990s, present Morocco is a beacon of fiscal prudence and restraint, and have the yield curve to show for it.
We are not out of the woods yet, unfortunately. The profligate expenditure on food subsidies and the post-Feb 20 generous upgrades in civil service paywage, unmatched with new fiscal receipts, and exacerbated by the 2007-2008 tax cuts, resulted in increased borrowings. The result has been swift: post-2007 10-years yield increased 500bps (or .5 percentage point) the same can be said of shorter maturities, so this is no sunspot easily brushed off. This generalized push on treasury yields upward has been observed in recent treasury surveys, and does not seem to bother that much policy-makers.
In a sense, this was to be expected: the Banking sector is short of close to 50Bn dirhams in the past 18 months, and shrinking liquidities mean investors make choices and require moderately higher yields, including those of the public debt, not to mention the rapid increase in PSBR. In a perverted way, investors are willing to require a moderate increase in required yield for treasury debt to place their dwindling liquidities, rather than invest them back into a morose exchange. This is the conundrum: why would investors do that? I am afraid I cannot provide suitable answer on that one.
Back to the public debt, the upward yield push in all maturities means these investors expect inflation to increase over the immediate and longer term, and their expectations are partly vindicated by the latest HCP and IMF projections. Let us not forget government finances benefited from the 15-years historically low inflation (observed elsewhere in the world but it is particularly true for Morocco) to switch gradually its debt structure to rely almost exclusively on domestic finances. In this particular sense, there is still quite comfortable room of manoeuvre for the government to keep piling the debt on before it even reaches 2002 levels – that is, 10y yields at 6%. But then again, one needs to account for the diminishing risk premium between 2000 and 2007, and its widening ever since.
Let us instead posit the risk premium is only the remaining term from the following equality, for some yield
where is the risk premium and the long-term, risk-free historical return. Let us also assume this long-term guaranteed return is close to 1% (this is a fairly realistic assumption) then we observe it a good fit: indeed, while required risk premium has declined significantly over the past 20 years or so, the trend weakened and remained more or less flat since 2007, and remained around 4.5% for the benchmark maturity. I would suggest government talking points about the deficit carry little weight in prompting investors to bring bond yields back close to the 4%, because the measures proposed to match the objective of 5.3% deficit relative to GDP in 2013, and 3% by then end of 2016 are two impossible things to reconcile.
The last remaining question, but not the least, is: “are public finances in trouble to warrant strong austerity?” undoubtedly, no. But these are equally unequivocal signs credible measures need to be taken to reduce the deficit amid shrinking liquidities and troubling signs from the current account and the currency reserve. But we are still far away from the so-called ‘cardiopulmonary arrest’.
It is always difficult to convey cautionary tones, or even urge pre-emptive moderate austerity measures (from my own point of view, anyway) when both sides of the pond are screaming Armageddon. But the fact remains levels of debt stock are increasing at high speed, and though these do not translate immediately in increasing yields, it would be then a near impossible task not to pursue hardcore austerity to bring long-term yields back to 4.5%. It is even more disturbing to notice marginal spreads between short and long term maturities (less than 8bps between 1y and 10y yields recorded on July 2012). The matter of concern, in short, is not default risk; it is however that of a government increasingly unable to fund programs and investments because paid interest is higher each year are creeping on in.