April 3, 2010 3:00 am

California and Kazakhstan - just who is the underdog?

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Maybe Bill Lockyer "not make benefit glorious state California"? Taking a page out of Greece's playbook, the peeved treasurer of America's largest state fired off letters this week to the chiefs of Goldman Sachs and other banks questioning their marketing of credit default swaps on California's debt. The instruments, he complained, "wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan".

Insulting indeed, but who exactly should be insulted? Home to Hollywood, Californians may derive their hazy image of Kazakhstan from Borat, Sacha Baron Cohen's satirical take on a country where he claims the main forms of entertainment include the "running of the Jew". The real Kazakhstan, although not problem-free, looks fairly solid compared to California and many other states - a fact that should spook investors in America's $2,800bn municipal bond market.

On paper, California's debt of $85bn supported by 37m citizens and the world's eighth largest economy looks more manageable than Kazakhstan's near-$100bn heaped on its poorer population of 16m. Go beyond headline figures though and Kazakhstan, with the world's 11th largest oil reserves, an economy that grew more than 8 per cent annually from 2002 through 2007 and unemployment of just 6.7 per cent looks positively vibrant next to the Golden State's joblessness of 12.4 per cent. And Kazakhstan's modest budget deficit and $25bn rainy day fund make it a paragon of fiscal virtue compared to a state forced to pay bills with IOUs last year and possibly again this summer. Unlike US states, Kazakhstan has its own currency and central bank. If it were to raise taxes or cut public services, wealthy Kazakhs could hardly defect to Kyrgyzstan the way Californians, already facing some of the highest levies and worst schools in the nation, might decamp to, say, Utah.

But such head-to-head comparisons do not even begin to spell out the relative woes of American states compared to many developing nations. In addition to their headline borrowings, equal to nearly a quarter of national output, states and cities have made billions more dollars in promises to current and future retirees. Pensions are nominally underfunded by an already scary $1,000bn according to the Pew Center for the States, but that uses their own rosy actuarial assumptions. Former Social Security administrator Andrew Biggs reckons the shortfall would be up to $3,500bn if calculated using a more conservative private sector methodology. Tack on another thousand billion or so for unfunded health benefits and America's states appear to have dug a hole so deep no amount of austerity could fill it.

Demographics, too, favour developing countries. Even with a relatively restrained birthrate, the median Kazakh is four years younger than the median American and will live 10 years less, cutting down the country's dependency ratio. And while California's innovators may or may not crank out future iPods, Kazakhstan will soon export even more oil as its giant Kashagan field and pipelines to booming China come on stream.

States' borrowing costs are supported by a minuscule historical default rate on traditional municipal debt but also by the distortion of being tax exempt. Lacking this feature, taxable California "Build America Bonds" given a direct federal subsidy yield 6.3 per cent for a 2022 maturity, some 2.4 percentage points above comparable US Treasuries. A more modest spread than Greek bonds over Germany's, to be sure, but then Greek credit protection is also pricier.

After resorting to Hellenic-style fiscal sleight-of-hand to plug this year's budget hole, it is alarming to hear California's officials blame the messenger in similar style. They must grasp that markets don't lie and creditworthiness is unrelated to superficial wealth. For example, Californians who illegally employ Mexican migrants as maids or gardeners might be surprised to learn that swaps traders consider its poor southern neighbour about half as risky a borrower as their state. Jagzhemash!

spencer.jakab@ft.com

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