Markets Insight
November 28, 2011 2:57 pm
Low growth and high debt is the sovereign curse
By Satyajit Das
It has become accepted wisdom – as popularised by economists Carmen Reinhart and Kenneth Rogoff – that sovereign debt levels become unsustainable when they rise above 60-90 per cent of a country’s gross domestic product.
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But, as government or corporate debt rarely ever gets repaid, the real question is whether that debt can be serviced and investor confidence maintained to allow it to be refinanced. In reality, the level of tolerable sovereign debt depends on a multitude of factors ranging from the currency of the debt to the level of interest rates and the debt maturity profile and structure of the country’s economy.
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While not exact, the sustainable level of debt can be approximated by another formulation commonly used by economists and analysts, which links the existing level of public debt, the current budget position, interest rates and growth.
.
Using this formula, eurozone economies need to achieve strong growth merely to stabilise their debt burdens.
.
Assuming borrowing costs of 4 per cent and a debt-to-GDP ratio of 120 per cent, Italy needs to grow at 4.8 per cent just to avoid increasing its debt burden where its budget is balanced. At current market borrowing costs of 7 per cent, Italy has to grow at an unlikely 8.4 per cent just to avoid increases in its debt levels.
.
Given low projected growth rates and elevated borrowing costs, Italy must reduce its debt levels significantly to avoid the risk of insolvency. Assuming interest costs of 4 per cent and growth of 2 per cent, Italy would have to run a budget surplus of 5 per cent per annum for 10 years to reduce its debt to 90 per cent of GDP. Alternatively, it must sell state assets to reduce its debt.
.
The toxic cocktail of high levels of existing debt, large and seemingly irreversible structural budget deficits, low growth rates and high borrowing costs makes the position of many European countries unsustainable. Beleaguered economies have to run budget surpluses (through spending cuts and tax increases), grow at very high rates, decrease their borrowing costs or achieve a combination of these merely to stabilise their debt.
.
The vulnerability of wealthy nations, financing the bail-out of weaker neighbours, is also evident. Assuming borrowing costs of 3 per cent and a debt-to-GDP ratio of 81 per cent, Germany needs to grow at about 2.4 per cent to avoid increasing debt levels. France needs to grow at even higher levels. If growth is low and additional liabilities are incurred to support Greece, Ireland, Portugal, Italy and Spain, then the problems are exacerbated.
.
Within this framework, Germany’s reluctance to allow a restructuring of the euro is explicable. Appreciation in the value of a restructured euro would make German exporters less competitive, slowing growth. This would trigger increased concern about the sustainability of German debt levels.
.
The reluctance of stronger countries to countenance significant debt writedowns is also explainable. Losses on sovereign debt holdings would trigger the need for states to increase their own borrowing to recapitalise national banks and support their funding operations. The simultaneous slowdown in growth as credit supply slows, combined with higher state liabilities, might trigger sovereign debt concerns, as they did in Ireland.
.
Events show that the combination of a large stock of debt, intractable, corrosive budget deficits, low growth rates and increasing borrowing costs can result in a rapid slide into a sovereign debt crisis. As interest rates increase as a result of rising investor concern about creditworthiness, attempts to cut the budget deficit merely reduce growth, exacerbating the problem. Without a significant reduction in the amount owed to creditors, the country is locked into a self-defeating cycle of austerity, continuing budget deficits and increasing public debt.
.
Following the global financial crisis, governments expanded their borrowings, replacing private sector, especially consumer debt, in a heroic bet to engineer a recovery. The increase in government debt will prove unsustainable if growth does not return quickly to high levels, driving a new phase of the global financial crisis.
.
It is really not a problem of debt; it is one of growth. But the economic growth of recent years was debt-fuelled. When asked for directions, the old joke is that some wise guy pipes up: “If you want to go there, then I wouldn’t start from here.” The same could be said about dealing with the problems of an over-indebted world.
.
Satyajit Das is the author of ‘Extreme Money: The Masters of the Universe and the Cult of Risk’ (2011)
.
But, as government or corporate debt rarely ever gets repaid, the real question is whether that debt can be serviced and investor confidence maintained to allow it to be refinanced. In reality, the level of tolerable sovereign debt depends on a multitude of factors ranging from the currency of the debt to the level of interest rates and the debt maturity profile and structure of the country’s economy.
But perhaps the most important determinant is the level of current and expected economic growth. A dynamic economy capable of high levels of growth, with the attendant ability to generate additional tax revenues and attract investment, can maintain a higher level of debt than one with lower growth prospects.
While not exact, the sustainable level of debt can be approximated by another formulation commonly used by economists and analysts, which links the existing level of public debt, the current budget position, interest rates and growth.
.
Using this formula, eurozone economies need to achieve strong growth merely to stabilise their debt burdens.
.
Assuming borrowing costs of 4 per cent and a debt-to-GDP ratio of 120 per cent, Italy needs to grow at 4.8 per cent just to avoid increasing its debt burden where its budget is balanced. At current market borrowing costs of 7 per cent, Italy has to grow at an unlikely 8.4 per cent just to avoid increases in its debt levels.
.
Given low projected growth rates and elevated borrowing costs, Italy must reduce its debt levels significantly to avoid the risk of insolvency. Assuming interest costs of 4 per cent and growth of 2 per cent, Italy would have to run a budget surplus of 5 per cent per annum for 10 years to reduce its debt to 90 per cent of GDP. Alternatively, it must sell state assets to reduce its debt.
.
The toxic cocktail of high levels of existing debt, large and seemingly irreversible structural budget deficits, low growth rates and high borrowing costs makes the position of many European countries unsustainable. Beleaguered economies have to run budget surpluses (through spending cuts and tax increases), grow at very high rates, decrease their borrowing costs or achieve a combination of these merely to stabilise their debt.
.
The vulnerability of wealthy nations, financing the bail-out of weaker neighbours, is also evident. Assuming borrowing costs of 3 per cent and a debt-to-GDP ratio of 81 per cent, Germany needs to grow at about 2.4 per cent to avoid increasing debt levels. France needs to grow at even higher levels. If growth is low and additional liabilities are incurred to support Greece, Ireland, Portugal, Italy and Spain, then the problems are exacerbated.
.
Within this framework, Germany’s reluctance to allow a restructuring of the euro is explicable. Appreciation in the value of a restructured euro would make German exporters less competitive, slowing growth. This would trigger increased concern about the sustainability of German debt levels.
.
The reluctance of stronger countries to countenance significant debt writedowns is also explainable. Losses on sovereign debt holdings would trigger the need for states to increase their own borrowing to recapitalise national banks and support their funding operations. The simultaneous slowdown in growth as credit supply slows, combined with higher state liabilities, might trigger sovereign debt concerns, as they did in Ireland.
.
Events show that the combination of a large stock of debt, intractable, corrosive budget deficits, low growth rates and increasing borrowing costs can result in a rapid slide into a sovereign debt crisis. As interest rates increase as a result of rising investor concern about creditworthiness, attempts to cut the budget deficit merely reduce growth, exacerbating the problem. Without a significant reduction in the amount owed to creditors, the country is locked into a self-defeating cycle of austerity, continuing budget deficits and increasing public debt.
.
Following the global financial crisis, governments expanded their borrowings, replacing private sector, especially consumer debt, in a heroic bet to engineer a recovery. The increase in government debt will prove unsustainable if growth does not return quickly to high levels, driving a new phase of the global financial crisis.
.
It is really not a problem of debt; it is one of growth. But the economic growth of recent years was debt-fuelled. When asked for directions, the old joke is that some wise guy pipes up: “If you want to go there, then I wouldn’t start from here.” The same could be said about dealing with the problems of an over-indebted world.
.
Satyajit Das is the author of ‘Extreme Money: The Masters of the Universe and the Cult of Risk’ (2011)
.
Copyright The Financial Times Limited 2011
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