California to Argentina: How Big a Nosedive?
The Great Contraction has exerted large negative effects on state and local government finances, as detailed by the Congressional Budget Office, prompting renewed concerns among the media and investors about the possibilities of bankruptcy and default. In fact, there have been few recent occurrences of municipal bond defaults, with state and local debt being extremely safe. However, the question of solvency going forward deserves serious consideration, especially as rating agencies and investment banks are both conflicted and have failed to ring the alarm for subprime, the PIIGS sovereigns, and many an emerging market (EM). In an earlier study, we examined whether U.S. state and local debt problems posed a systemic risk; we now try to gauge just how big an economic downturn would be consistent with credit metrics of a U.S. state approaching the levels witnessed for EMs during sovereign default episodes. In looking at well-known EM defaults of the past two decades we observe that:
- Most sovereign ratings were already relatively deep into junk territory years before default. Debacles such as Enron, WorldCom, Lehman and the subprime CDOs have tarnished the record of rating agencies, but sovereign and municipal debt has proven an easier ballgame—though Ireland and Iceland show that even triple-As are not bullet proof, and Greece was rated single-A until the eve of the eurozone crisis.
- Debt-to-GDP ratios were roughly 10 times as large as the current figures for most states.
- Deficits of weak countries were often of the order of 5-10% of GDP in the instances of sovereign default; state budget gaps are usually one-tenth this size, and need to be closed each year without recourse to permanent borrowing. For example, the total budget shortfall of states for 2012 is around US$100 billion or under 0.7% of U.S. GDP, according to the Center on Budget and Policy Priorities (June 2011).
- “Deep Recession” versus Depression. EM indebtedness and debt sensitivity to recession was an order of magnitude higher than those of states, and was enough to push their debt trajectories onto an exponential, unsustainable path. States, on the other hand, would have plenty of room to raise revenues or cut services, unless a true Depression was to paralyze economic activity.
- The average interest debt service as a share of total revenues for U.S. states pales in comparison with EM metrics at the time of default. Past EM crises were often triggered in part by large rises in U.S. interest rates, e.g. in the early 1980s and 1994, and short debt maturities and reliance on capital inflows. In contrast, most states and localities have very long maturity profiles, and have taken full advantage of low interest rates and the multiyear BAB program; rising interest rates would only filter into debt dynamics over time (pronounced deflation would be an immediate disaster).
To turn Illinois 2006 into Illinois 2009, the worst recession in the post-WWII era was needed, but it “only” resulted in the ratio of interest to revenues rising from 4.8% to 7.4%, and revenues only dropped for a few quarters. The bulk of this increase was caused by market losses in pension fund assets; excluding these losses would have produced a 5.3% ratio. Overall, from 2006 to 2009, interest went up by 18% (despite large rate cuts). Still, the amount of budgetary funds consumed by debt payments is nowhere near Greece’s current level (where it consumes 14% of revenues), let alone that of EMs that went bust with interest eating up 25-40% of budgets, and debt service even higher. Using current metrics on state finances, and relying on various studies detailing the sensitivity of state revenues to economic activity we deduce the level of macro “shock” that would vaporize revenues to such an extent that now-solid credit metrics become not just worthy of a speculative grade, but comparable to those of EMs on the brink of default. For detailed analysis, see What Would it Take to Make a State Go Bust?”
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