California ills give US a Headache

California’s fiscal crisis is in danger of becoming a serious headache, not just for the state and its feuding politicians in Sacramento, but for the entire nation.

In public, federal government officials talk about California’s problems as if they were ringfenced – a crisis for the state but with few national ramifications. They know the slightest whiff of federal intervention would take away the incentive for California’s politicians to agree on tough spending cuts and tax increases. But they know they cannot ignore a fiscal crisis in the most economically important state in the middle of a global financial crisis. So they are keeping a careful eye on events and it would be surprising if they were not also reviewing the options at their disposal to mitigate the damage.

California has a budget deficit of $26.3bn (€18.85bn, £16.18bn) on revenues of just $113bn, according to Keefe, Bruyette and Woods, a broking firm. It has a balanced budget rule that forces it to eliminate the deficit but no agreement as to how. It has already effectively decided to selectively default – paying vendors with IOUs rather than cash. Worse could follow if the impasse is not resolved soon.

The worst case scenario would be a default by the state which has $59bn in general debt, $8bn in bonds linked to securitised revenues such as tolls and $2bn commercial paper, according to Standard and Poor’s, the rating agency. A California default would be a shock for fragile financial markets. While no other state is in quite as difficult a position, there would be danger of widespread contagion in US markets and beyond.

Default still looks like a so-called “tail risk” – a high cost but low probability event. California’s constitution makes debt service a high priority. Its main constraint is cash flow. The decision to pay bills in IOUs saves cash for debt servicing and that should be enough for now. But it is not sustainable indefinitely. In the absence of a fix for the underlying deficit, vendors and banks will eventually lose faith in the value of the IOUs, forcing California to pay for vital services in cash instead. Moreover, there are institutional reasons why the budget gap is proving difficult to close.

Aside from the absurdity of having to balance the budget in the midst of the worst recession in half a century, California’s fiscal flexibility is diminished by other statutory restrictions, mostly imposed by state referendums known as propositions. These restrictions make it exceptionally difficult for the state to raise property taxes or cut basic education spending. About 25 per cent of revenue is, meanwhile, ringfenced.

If the gridlock continues for months and the risk of default escalates, it would take a brave Treasury secretary not to step in with some kind of guarantee, credit line or outright bail-out for California. The immediate outlays involved would not be vast compared with federal bail-outs for banks and carmakers. Yet, the federal government could not help California without aiding other troubled states, and a de facto or even de jure federal guarantee for all state debt would add a huge fiscal burden. Nor is it clear what the exit strategy would be: if the federal government blinked this year, it presumably would blink again next year if the problems were not resolved.

The most likely scenario is that California’s feuding politicians eventually reach a deal to close the $26bn budget gap. But even then there would be ramifications. The state’s economy is already weak; unemployment is 11.5 per cent and the multiplier effects of $26bn in geographically concentrated spending cuts and tax increases could be high.

Moreover, as KBW highlights in a research note, cutbacks at the state level will put additional pressure on highly stretched counties and municipalities. Like the state, these entities have little latitude to raise revenues. State-level fiscal consolidation could easily lead to a rash of defaults at the local level, which could roil the market for municipal debt nationally. If this happened, the federal government might have to support the municipal bond market, possibly through a guarantee scheme with risk-based pricing. Alternatively, it could decide the best antidote to state fiscal contraction is further federal stimulus.

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Source: http://www.ft.com/cms/s/0/82185bf0-6f01-11de-9109-00144feabdc0.html?nclick_check=1

Tags: California’s fiscal crisis, KBW, Public Finance, Government finance, California has a budget deficit of $26.3bn, on revenues of just $113bn, Keefe Bruyette Woods, Global Economic News, Global Economic Pulse, IOU’s, Standard and Poor’s,

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UK Economy Shrinks Most In 50 years

The UK economy shrank by the most in more than half a century in the first three months of the year, according to revised figures which were much weaker than originally estimated.

The 2.4 per cent decline in gross domestic product was sharper than the 1.9 per cent initially calculated, the Office for National Statistics reported, and was greater than the 2.1 per cent fall expected by economists. About half the revision was due to the introduction of new construction sector data and the rest was bacause of more complete services sector figures showing a sharper decline.

Not since 1958 has the quarter-on-quarter decline in GDP been greater, while the 4.9 per cent drop compared to a year earlier was the largest since records began in 1948. “‘You’ve never had it so bad’ seems the most apt summary of the state of the UK economy in Q1,” said Ross Walker, economist at RBS. “Although to some extent this is ‘old news’, it does serve to emphasise the size of the hole out of which the UK must climb.”

The precipitous decline in GDP in the first quarter reflected the fallout after the credit crisis escalated dramatically from September of last year onwards and highlights the depth of the recession that the UK has been suffering. But since the end of the first quarter there have been growing signs that the economy is stabilising. Manufacturing output actually grew in March and April, while survey data suggested the economy has returned to growth.The respected economics thinktank, the National Institute for Economic and Social Research, said it thought the economy began to grow again in April.

“The survey data suggest we have at least stopped digging, but the economy remains on course for a lacklustre pace of recovery,” Mr Walker said. The Bank of England has warned that the economy faces a slow recovery, as banks remain fragile and lending weak.

The output of the construction was revised down to show a 6.9 per cent decline from the first estimate of a 2.4 per cent drop. However, the fall in output was actually less severe than the 9 per cent fall that a more recent ONS revision had suggested, which had led many to expect GDP to be revised down sharply. Services output, which makes up about three quarters of the UK economy, was revised down to see a drop of 1.6 per cent rather than the 1.2 per cent orginally reported.

“Revisions to GDP are larger than usual, reflecting greater uncertainty in measurement during a period of rapid change in economic activity,” the ONS said. The GDP figures confirmed that the recession began in the second quarter of last year, after the economy shrank by 0.1 per cent in the April to June period, rather than the 0.0 per cent decline originally reported.

The economy contracted by 4.9 per cent from its peak in the first quarter until the first quarter this year. That is worse than the 2.5 per cent drop in the 1990s recession, but less than the 5.9 per cent fall in the early 1980s recession. Despite the dramatic contraction in the economy rating agency Fitch reconfirmed the top triple-A rating on the UK’s sovereign debt at stable - along with the US, France and Germany - refusing to follow rival Standard & Poor’s which recently changed the UK’s debt outlook to negative.

The household saving ratio fell to 3 per cent from 4 per cent in the final quarter of last year, as households’ real disposable income dropped by 2.4 per cent due to lower earnings, but consumption did not fall as sharply. Business investment fell by 7.1 per cent during the quarter. Inventories made a smaller drag of 0.4 percentage points out of the 2.4 per cent fall in GDP, compared to the previous estimate of 0.6 percentage points.

“The UK national accounts ... underline the fact that the economic recovery is built on very fragile foundations,” said Capital Economics. “With the annual rate pulled down from -4.1 per cent to -4.9 per cent, average GDP growth in 2009 now looks likely to be -4 per cent or weaker rather than the -3.5 per cent we previously expected.

“Note too that the breakdown is not pretty, with the renewed fall in the household saving ratio from 4 per cent to 3 per cent underlining that the adjustment in the household sector has a long way yet to go.”

Source: http://www.ft.com/cms/s/0/971b65f6-6551-11de-8e34-00144feabdc0.html

Tags: UK, UK Economy, Economic contraction, Capital Economics, UK National Accounts, Triple-A rating, GDP, Fitch, FT, Global Economic News, S&P, Standar and Poor’s, Inventories, Office for National Statistics,

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