What is sovereign debt?
Sovereign or public debt is the term used to describe money owed not by a nation but by a nation’s government. It’s the source of the current debt crisis.
Bank bailouts resulted in private debt being made public and, in an attempt to kick-start slumping economies, massive fiscal stimulus packages were undertaken. Government debt increased hugely as a consequence.
Governments issue bonds to finance their debt. Those purchased by its own citizens constitute a domestic debt while those borrowed overseas from non-residents are an external debt.
The distinction is important, especially if you happen to be Greek. At the end of 2009, Greek sovereign debt stood at 113% of GDP, 82% of which was external. Interest payments on that debt leave the country, depressing economic activity and making further repayments more difficult.
Italy, on the other hand, had public debt of 115%, of which only 19% was external. Italy’s interest burden is largely paid to Italians, which is why its problems aren’t as serious as other PIIGS.
The other consideration is the currency in which debt is issued. Whereas most countries have to issue bonds in a foreign currency (typically the US dollar), the United States does not. If the US gets into trouble, it can simply print more dollars to repay debt (something it’s busy doing right now).
Countries carrying a large percentage of external debt don’t have that option, which is why Portugal, Ireland, Greece and Spain are in more serious trouble.
Is sovereign debt bad?
It depends. Societies’ religious background colours views; many see debt as a moral failing. In Sanskrit, Hebrew and Aramaic, the word for debt and sin are essentially the same so discussions of the subject can sound like a morality play — debt is bad, we have sinned, we should pay it all back and suffer. We can see the political expression of that in the Tea Party.
But government debt is different. It’s constantly refinanced and investors accept it because the money is invested in health, education, infrastructure and wars, which tend to be economically beneficial. But that’s not to say countries don’t get into trouble from too much debt; they do, quite a lot.
So countries do default on their debt?
Conventional wisdom suggests debt defaults are infrequent. History suggests the opposite. In This time it’s different, Carmen Reinhart and Kenneth Rogoff examine “default episodes” over eight centuries and establish that, especially among emerging economies, defaults aren’t exceptional at all.
Between 1300 and 1799 the emerging economies of France and Spain defaulted eight and six times respectively. In the 19th century alone Spain defaulted seven times. From the Great Depression of the 1930s to the 1950s, nearly half of all countries were in default or “restructuring” — a euphemism for default — representing almost 40% of global GDP.
More recently, there was a wave of defaults in the 1980s and ’90s, including Russia in 1998 then Argentina, which defaulted on part of its external debt in 2002. Countries default all the time, even in Asia and Europe.
Ominously, Reinhart and Rogoff remark that “whereas one and two decade lulls in defaults are not at all uncommon, each lull has invariably been followed by a new wave of default”. The period between 2003 and 2007 was one such lull. We all know what happened next.
Also, we should remember that most defaults aren’t about an inability to pay but, at least in a democracy, a lack of political will to do so. The alternatives to default are austerity measures — cutbacks on government services — and tax increases. Neither are big vote winners. It’s much easier for politicians to punish those (non-voting) horrible, dirty foreigners stupid enough to lend them money in the first place.
What are the consequences of default?
Let’s take Argentina as an example. After its $132 billion default in 2002, investors fled the country, causing a currency collapse (in fact, in anticipation of default they were leaving in droves before it). The value of the countries’ exports plummeted despite the currency falling. Without financing, the government was forced to cut expenditure, slashing state pensions.
Private sector wages fell, unemployment soared to 20%, inflation skyrocketed as the cost of imports rose and the government printed money, debasing the currency further. In a year, the economy shrunk by an incredible 13% and about a quarter of the population resorted to bartering. Bartering!
The long-term consequences are most evident in the credit ratings and rates on Argentinean bonds. Japan is carrying debt of 225% of GDP, the highest in the world. It pays 1% on its 10-year bonds. Argentina, with debt standing at 52% of GDP, pays 10%. Argentina has a credit rating of B; Japan AAA. Much of that differential is explained by Argentina’s default. Investors want a higher return for trusting them again.
Why the panic now?
First, no one’s panicking about Australia — quite the opposite. The problems are in the largest economies of the developed nations. And it’s not debt per se that’s the problem — it’s the extent of it and what it’s been used for.
In 2006 the average debt level of the G7 nations (Canada, France, Germany, Italy, Japan, the UK and the US) was 84% of GDP — not bad enough to send us all to the great margin loan in the sky. By 2010 it was 112%, the highest level since World War II.
Those averages disguise some alarming figures. In the United States debt has risen from under 60% of GDP to well over 100% in 2010. According to the IMF, in 2010 Japan, Greece, Italy, Belgium, Singapore, Ireland, the US, France, Portugal, Canada, the UK and Germany carried government debt of 75% or more, far greater than economic powerhouses such as Malawi (40%) and Uzbekistan (10.4%).
How can countries fix their debt problems?
The first option is economic growth. If GDP is increasing at a rate faster than the increase in national debt, although the debt is rising in absolute terms, as a percentage of GDP it’s falling. That’s good.
Countries such as the US, the UK and Japan, which can take on more debt cheaply, have this option. For Spain and Italy, with 10-year bond rates about 5%, it’s a remote possibility. For Greece, with a 10-year bond rate of 17%, it’s out of the question.
Reducing debt by cutting government expenditure and increasing revenues is the second policy choice. The UK in particular is following this strategy, favouring cutbacks over tax increases.
The trouble is that increasing taxes and cutting back on government expenditures at a time when economic conditions are already shaky can make things worse. In that sense, these two options conflict.
The third policy option is to inflate the problem away. Inflation reduces in real terms the debt owed, which is why indebted governments have a big incentive to encourage inflation. Although governments won’t admit to it, policies such as quantitative easing (see Quantitative easing made easy) have this as one of their aims.
Currency devaluations have much the same effect, which is why the US dollar and UK pound are at historically low levels. Lower exchange rates also benefit economic recovery, making exports cheaper and imports relatively more expensive. In the aftermath of the GFC, Iceland, as well as letting private banks collapse, used a currency devaluation to great effect.
Unfortunately, indebted European countries tied to the Euro at a rate set largely by Germans aren’t able to do this. That’s why the situation in Europe, where the problems are structural and immediate, is more pressing than in it is the US.
Remember also that a currency’s value is relative; countries can’t all devalue at the same time. With a troubled US and Europe, and half of the rest of the world pegged to the US dollar, devaluation is unlikely to do the trick.
We’ll be OK because of China, right?
Not necessarily. The US and Europe are China’s two biggest markets. If things take a turn for the worse in those economies, China will be affected.
China is an export-driven nation; domestic consumption is insufficient to compensate for another deep recession in the US and Europe. If that were to occur, we could expect to see a rapid fall in commodity prices, the local currency and our terms of trade.
China also has its own problems, including massive (and under-reported) local government debt, social unrest and inflation concerns. It’s not the beacon of economic stability it’s made out to be.
What are the chances of a double-dip recession?
The global economy is three years into a debt recession, which tend to last longer and are more severe than normal recessions. Charles R Morris in The Trillion Dollar Meltdown said: “A credit bubble is different. Credit is the air that financial markets breathe, and when the air is poisoned, there’s no place to hide.”
We’re all breathing toxic air and it needs cleaning. That takes time. Look at the Japanese and their lost decade. We can expect a few more problems yet, although that doesn’t mean we’re going to face Japan-style problems.
How does this affect my investment strategy?
First, don’t panic. Corporate debt is much lower, corporate profits much higher. The banks have been recapitalised. This might feel like 2007 all over again but it doesn’t look like it.
Second, understand that the local currency isn’t the safe haven it appears. A weak US dollar and an unsustainable and risky Chinese stimulus program make it look that way. Australia remains a small economy heavily reliant on the financial and resources sectors. That’s why investors should consider overseas exposure.
Pricing power is also going to be important. That means you should buy best of breed companies and hold some cash — volatile markets are likely to be the norm.
Also, be more demanding with your valuation estimates. If a company reaches fair value then consider selling it for cheaper stocks (it’s sensible to swap cheap for cheaper still).
Nevertheless, prepare for a world of lower growth. Dividends will become more important and low interest rates more prevalent. That should influence the stocks you buy and sell.
In the latest Platinum Quarterly Report, Kerr Neilson posits that more than two thirds of the total real return from equities in the period 1900 to 2008 came from dividends. There’s no reason why the next 90-odd years won’t follow a similar pattern.
Finally, acknowledge that humans have an amazing capacity to muddle through. Crises pass and problems are solved, after which we forget they existed in the first place, thus creating the conditions for them to happen all over again. We are indeed a strange mob.