Swedish test for Euro "high-yielders"

Most people not involved in the international bond markets will be unaware that a new little coterie of bonds has emerged in the last few months - the "European high-yielders". These are the government debt of financially dodgy European countries , wherethe market is demanding a premium of up to 5 percentage points over the equivalent German bond.

It is, if you abstract from the unflattering implicit message it gives, an interesting sector, for it offers double-digit yields. If the country concerned manages to pull though with only a modest devaluation and without a default, good profits can be made. But, if European countries find they have to default, the losses could be enormous. Today sees the first of a series of tests of this high-yielding segment of the European bond market this year, as the new Swedish government announces its budget.

Last week Swedish debt was downgraded by Moody's, the US bond rating agency, because of a public sector debt equivalent to 90 per cent of gross domestic product (and rising rapidly). Even after today's measures, the total Swedish fiscal deficit is likelyto be equivalent to well over 10 per cent of GDP this year, and the growth of the deficit proportionate to GDP is, at best, expected to stop only in 1998.

We will have to wait and see whether the spending cuts and tax rises to be announced will satisfy the markets and achieve the stabilisation of the public sector's debt as planned. Indications yesterday of the size of the cuts in public spending gave a sharp boost to bond prices, but it is not at all clear from the various reports what was new to this package and what was part of the emergency package announced three months ago.

The quality, rather than the quality, of the changes seemed discouraging as there were suggestions in the Swedish press that there would be massive additional spending on training and job-creation, including tax breaks for those who take on the long-termunemployed. In many countries that might well be a sensible approach, but there are at least three reasons to suspect that in Sweden the measures are unlikely to be effective.

The first is that the Swedish public sector is so large that it is difficult to see further expansion as a solution. The second is that while offering additional training and foreign study positions for young people has the immediate effect of taking them off the unemployment register, in public finance terms it is expensive, and, given the lack of private sector job opportunities, the training may simply create higher-skilled unemployed. Third, private comments by those in government suggest it may have an unrealistic expectation of the fiscal impact of its policy changes: that there is a lot of wishful thinking not just that Sweden can grow its way out of its debt crisis, but that improved confidence will cut the cost of debt service.

The bond markets are well aware of these points and will look very closely at the fiscal arithmetic. If, after due consideration, the numbers are thought not to be credible, expect a currency crisis, and a austerity package in the spring.

There is a wider question here: to what extent is Sweden a special case? In terms of its running deficit Sweden is - with Finland and Greece - the most "fiscally-challenged" European nation. In terms of the proportion of debt to GDP, Belgium and Italy are worse. Belgian bonds have escaped pretty lightly, but Italian ones are clobbered from time to time. Yesterday was just such a time: following the Swedish downgrading, there were suggestions in the market that Italian debt would soon be downgraded too. Both the major rating agencies denied this, but currency and bond markets moved down. The focus of attention switched to Spain yesterday, where political uncertainty has combined with a weakening currency to give the bond markets cause for concern.

The danger here is that the markets are hunting in a pack, lumping all European high-yielders together rather in the way they do Latin American debt. This in unfair, for while there are fiscal problems common to many European countries these are different sovereign governments, with different cultural attitudes to the challenge of indebtedness. There is no question that all these European countries could earn their way out of their difficulties - all they have to do is to impose a fiscal adjustment not much larger than Britain has done in the last couple of years.

True, they would then have to follow that with a sustained period of deficit-cutting to last the best part of a generation, and that would be difficult in political terms. It should not be impossible to restrict the rise in living standards to, say, 1 per cent a year, while economic growth ran at more than 2 per cent. Given the combination of indebtedness and an ageing population in much of Europe, such a shift of resources is inevitable.

But engineering such a shift takes time. There is a powerful fiscal argument for getting on with deficit-cutting, for the longer it is delayed the harder it becomes. But European finance ministries also need to see some practical rewards in the shape of lower borrowing costs, and if all the high-deficit countries are lumped together by the markets it is tough on the virtuous.

So the market response to Sweden's efforts matters not only to the Swedish government and those who have lent it money, but to all suspect European borrowers, for a further loss of confidence in these "high-yielders" would make their financial adjustments more urgent and harder.