The Responsibility of HOA Reserve Reporting: Deciphering California Civil Code Article 1365

It is a little known fact that the preparation of a common-interest-development reserve study is not required to be done by a third party, section 1365.5 (e) - “At least once every three years, the board of directors shall cause to be conducted…a study of the reserve account requirements…”. No reference to third parties, so a study can be prepared internally by an association. Also, California Civil Code Article 1365 (Article 1365) makes no reference to requirements of updating the study in the second or third years.
Does this mean that associations (HOAs/POAs) should be preparing their own reserve studies? Probably not. Most associations do not possess the professional expertise or experience required to prepare “a reasonably competent and diligent visual inspection…as part of a study”. But the overbearing reason for the board of directors to engage a third party to prepare a HOA reserve study or plan is to provide liability relief. There are many competent Reserve Specialists that are capable of “competent and diligent visual inspection”, but are they capable of interpreting Article 1365 reporting requirements?
The interpretation and controversy of deciphering Article 1365 has been going on for more than two decades. Based on history, the debates will probably go on for another couple of decades due to the many layered amendments incurred which provide confusion and redundancies.

Deciphering the Reserve Requirements of Article 1365:

Reserve requirements are not the only subject that Article 1365 addresses. The reserve requirements are intertwined with operations, reporting, distribution, disclosure, assessments, foreclosures, meetings, and the subject matter goes on and on. It is the board of directors that are ultimately responsible to abide by Article 1365 which is extremely difficult to accomplish without the help of competent management and third party professionals. The challenge for the board of directors is determining how and who will ultimately prepare the reserve information that will be disseminated to the owners. It is probably just as hard for a board of directors, management or the Reserve Specialists to determine who is taking what responsibilities of the reserve reporting requirements of Article 1365.
Section 1365.2.5 (a) states: “The disclosures required by this article with regard to an association or a property shall be summarized on the following form: Assessment and Reserve Funding Disclosure Summary”
When reading Section 1365.2.5 (a), “The disclosures required by this article…”, the article is Article 1365 in its entirety. The form “Assessment and Reserve Funding Disclosure Summary” (summary form) outlines certain defined or selected reserve reporting requirements of Article 1365 but not all of them. The preparation and distribution of this summary form appears to be an annual requirement in which Section 1365.2.5 (a)(3) and (6) refer to “the most recent reserve study”. Section 1365.5 (e) which requires a reserve study, “At least once every three years…”, makes no reference to prepare or include this summary form. This would leave the association to prepare this summary form unless the board of directors engaged a third party to do so. Are the summary form and the reserve study separate requirements (one being annual and the other every third year)? Should a Reserve Specialist be engaged to prepare this summary form? Welcome to the confusion and redundancies of Article 1365. What are the other reserve requirements of Section 1365 (e):
“The study required by this subdivision shall at a minimum include:
(1) Identification of the major components that the association is obligated to repair, replace, restore, or maintain that, as of the date of the study, have a remaining useful life of less than 30 years.
(2) Identification of the probable remaining useful life of the components identified in paragraph (1) as of the date of the study.
(3) An estimate of the cost of repair, replacement, restoration, or maintenance of the components identified in paragraph (1).
(4) An estimate of the total annual contribution necessary to defray the cost to repair, replace, restore, or maintain the components identified in paragraph (1) during and at the end of their useful life, after subtracting total reserve funds as of the date of the study.
(5) A reserve funding plan that indicates how the association plans to fund the contribution identified in paragraph (4) to meet the association’s obligation for the repair and replacement of all major components with and expected remaining life of 30 years or less…”
The summary form is primarily focused on current and future reserve fund balances, requirements and percent funded (Section 1365.2.5 (b)(4), “…the amount of reserves needed to be accumulated for a component at a given time…”). While the reporting requirements of a reserve study are different from the summary form, the elements of the reserve study are necessary in preparing a summary form. It is not the question of what comes first the chicken or the egg. A reserve study must be prepared before a summary form can be produced. The question then becomes when should a reserve study be prepared?
Considering the following: Section 1365 (a), “A pro forma operating budget, which shall include all of the following:” Section 1365 (a)(2) A summary of the association’s reserves based upon the most recent review or study conducted pursuant to Section 1365.5…”. Section 1365 (a)(2)(B), “As of the end of the fiscal year which the study is prepared:”. Section 1365 (a) (4), “…a copy of the operating budget shall be annually distributed not less than 30 days nor more than 90 days prior to the beginning of the association’s fiscal year.”
Based on Article 1365 requirements, a reserve study would have to be prepared before the annual distribution requirements (30 to 90 days prior to the beginning of the association’s next fiscal year) if it’s conclusions were to be utilized in a timely annual distribution. For example, if the association’s beginning of fiscal year is January 1, 2010, the annual distribution of documents should be accomplished by December 1, 2009 requiring the reserve study preparation to be prior. As with other disclosures, the summary form would also appear to be required in this time frame.
Even though a reserve study is only required every third year, Section 1365 (a)(2) still requires annual reserve reporting requirements separate from the summary form as follows:
  "(A) The current estimated replacement cost, estimated remaining life, and estimated useful life of each major component.
   (B) As of the end of the fiscal year for which the study is prepared:
         (i) The current estimate of the amount of cash reserves necessary to repair, replace, restore, or maintain the major components.
         (ii) The current amount of accumulated cash reserves actually set aside to repair…
   (C) The percentage that the amount determined for purposes of clause (ii) of subparagraph (B) equals the amount determined for purposes of clause (i) of subparagraph (B).
   (D) The current deficiency in reserve funding expressed on a per unit basis. The figure shall be calculated by subtracting the amount determined for purposes of clause (ii) of subparagraph (B) from the amount determined for purposes of clause (i) of subparagraph (B) and then dividing the result by the number of separate interests within the association…
(3) A statement as to all of the following:
    (A) Whether the board of directors of the association has determined to defer or not undertake repairs or replacement of any major component…
    (B) Whether the board of directors of the association, consistent with the reserve funding plan adopted pursuant to subdivision (e) of Section 1365.5…
    (C) The mechanism or mechanisms by which the board of directors will fund reserves to repair or replace major components…
    (D)Whether the association has any outstanding loans…
(4) A general statement addressing the procedures used for the calculation and establishment of those reserves…”
The annual reserve reporting requirements in Section 1365 (a) (2) appear to have most of the ingredients of a reserve study. Does this mean that a reserve study needs to be done every year so the information in the reserve study can be extracted to fulfill the annual reserve reporting requirements of Section 1365 (a)(2)? A complete reserve study would include “a reasonably competent and diligent visual inspection” which is not required annually. An update of the previous year reserve study or the previous reserve study update per Section 1365 (e) would be necessary in producing the annual reserve reporting requirements of Section 1365 (a)(2).
Annual reserve reporting requirements (Section 1365 (a)(2)), the summary form (Section 1365.2.5 (a)) and reserve studies (Section 1365.5 (e)) makes for confusion and redundancies. If the confusion and the redundancies could be removed and proper grammar injected, we might find the original Article 1365 or something everybody could understand and agree on.

Analysis of Indian Union Budget 2010-11

The Union Budget 2010-11 was another remarkable landmark in the long political history of Finance Minister Pranab Mukherjee. He has maintained many of the union government’s large fiscal policies and has further provided relief to the rising earning middle class of India. Thus, in a broader sense, a totally consumption-based model for growth has been pursued. In other words, the budget allows both rural and urban populace to have more money to spend and continue this remarkable economic boom we have seen in the last decade.

The Finance Minister is looking to close this economically historical decade, by targeting the high growth rates we have been looking to get from the start of the millennium. The target looks "refractionally" even higher thanks to global recession. But, India has done well to decouple itself from the profligate West and its government’s prudent and somewhat conservative outlook has paid off enormously.  

India’s amazing recovery growth story is not just another milestone, but has many signs to read. 

The first is how India has strong domestic consumption and its economy may not be as dependent on exports, as it first appeared. Second, it places India at the centre of the global economic rebalancing along with China, taking in favour of Asia. Third, it sets a precedent of kinds to other political bigheads who are yet write economic policies, to maintain populist fiscal measures.

The annual budget announcement has become a major part of an ordinary citizen’s life today, with due credit to the Indian press, who seem to forget every other news happening for a week or so. But, why not! People’s budget expectations are so necessary in the spirit of the democracy and are what I believe to be the biggest ‘RTI’ of all. Can you think of any other occasion in a year which allows people to make the government to be more accountable to them? Perhaps not, and so I wish to support the further cause by breaking the budget and to even cover issues not usually spoken about in the media as well. So let us begin this, by having a look at the government’s bottom line first.

Taming the Fiscal Deficit

The most important announcement which was eagerly awaited by all was the call to restraint the growing fiscal deficit. The fiscal deficit was being chiefly blamed for the high levels of inflation India has witnessed over the last 6-8 months. However, I am of the opinion that there were many other serious administrative problems which were major aggravators.

So as expected the finance ministry has simply cut, copied and pasted the 13^th Finance Commission’s recommendations and targets. (See the chart for more clarity). The finance minister has committed to bringing down the fiscal deficit 2009-10 level of 6.7 % of GDP to 5.5% of 2010-11 GDP. Also the government has remembered to realign itself with requirement of the Fiscal Responsibility and Budget Management Act of 2003. The government has announced to bring down the deficit to 3% level by the end of next 4 years. 3% target is under the rules of the Act. Although, I think the Act will give more leeway to the FM to dictate his sudden austerity mood swings!

The Union government was well on track to achieve its FRBM targets till the global financial crisis came about. The government had to quickly change gears and announce huge expansive fiscal policies to maintain growth. 

For the year 2007-2008 the budget deficit was just 2.6% of the GDP. However, going back to such levels will take much longer than what it took to go up.

The foremost reason being, that a calibrated and planned approach will steer clear of the uncertainties over crowding out private investment. Furthermore, the danger of Japanese like bust on pre-mature withdrawal of government support. Second, being the political will required to renounce the populist policies. After all they all stand for re-election.

The budget has done well to quell fears of high fiscal deficit led inflation. We will see the results over the next 2 quarters. I still have my doubts on its inflation tackling effects. Nevertheless, words must be converted into action. Or like Obama says,” Words must mean something!”.

Republicans won't compromise on budget to avert government shutdown: Sen. Charles Schumer

DAILY NEWS WASHINGTON BUREAU

Wednesday, February 23rd 2011, 4:00 AM

Applewhite/AP

House Budget Committee Chairman Paul Ryan, R-Wis., and the Senate Budget Committee's top Republican, Sen. Jeff Sessions of Alabama, right, deliver GOP response to President Obama's budget last week.
 

Somodevilla/Getty

Sen. Charles Schumer (D-NY) said the Republicans won't compromise to avoid a government shutdown.

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The Republicans just won't take "Yes" for an answer to their demands to cut the budget, Sen. Chuck Schumer charged Tuesday afternoon.
With the battle over spending cuts getting more heated and the threat of a government shutdown looming closer when funding runs out March 4, Schumer and Senate Majority Leader Harry Reid held a hastily arranged conference call to complain the GOP has nixed their latest offer to negotiate a deal.
"Leader Reid offered an olive branch to House Republicans and they flatly rejected him," Schumer said.
That olive branch amounted to a reminder that Senate Democrats passed the current funding resolution last December that's already $41 billion less than President Obama wanted, and a promise to seek deeper cuts in return for a 30-day temporary spending bill to keep the government going beyond next week.
"Now we are saying to Republicans, we’re willing to go deeper," Schumer said.  "We’re willing to sit down and negotiate and look beyond the $41 billion and find extra cuts to take us through the year.
"The House Republicans are saying that’s not good enough," Schumer fumed. "The House Pepublicans won’t take yes for an answer."
Earlier, House Majority Leader Eric Cantor (R-Va.) charged that it was the Democrats who were pushing a government shutdown by refusing to take up the House's bill that cuts $61 billion from last year's spending levels..
"Senate Democrat Leader Harry Reid has yet to offer a plan and instead almost seems as though he’s hoping for a government shutdown to occur for political gain," Cantor said. "Let me be clear, a government shutdown is not an acceptable outcome, and I call upon Leader Reid to commit to a good faith effort to work with us and take that threat off the table."
Schumer argued that if there's bad faith, it's in being unwilling to accept a 30-day extension so the two sides can talk.
"They want cuts right now on their terms before negotiations take place," he said. "It’s not an act of good faith, it’s an act of a group that will not be satisfied with anything less than a shutdown of the government."
He and Reid took issue with the threat of a shutdown coming from them, as well.
“We are taking it off the table. They have refused to do it," Schumer said. "They have been asked repeatedly on television… they won’t. We have."

Health Dept. may put bar codes on restaurant letter grades to access inspection information

DAILY NEWS CITY HALL BUREAU

Wednesday, February 23rd 2011, 4:00 AM

Matthews/AP

The Health Department's restaurant letter grades may soon come with bar codes that can be scanned by cell phones, allowing diners to see the violations behind the establishment's rating.

New Yorkers may soon be able to wave their cell phones over restaurant letter grades to see if mouse droppings or dangerous food temps are to blame for a less-than-stellar score.
"The Health Department is exploring the possibility of putting bar codes on restaurant letter grades that would take consumers directly to a restaurant's latest [inspection] results," spokeswoman Erin Hughes said.
The Health Department puts the details behind the A, B or C grades online, but bar codes would make that information easily accessible at a restaurant's door.
It's among a host of efforts the city is considering as it looks for ways to put more information in people's palms.
"People can communicate and get information in ways that they never could before," Mayor Bloomberg said yesterday.
Hizzoner announced that the Buildings Department is putting bar codes on construction permits so people with smart phones can access details about the project, the building and whether its owner has been fined for code violations.
Bloomberg said he'd like to expand bar codes to other city functions like helping tourists get information about attractions.
"This is just the beginning," the mayor said. "Once you get this to work, there's an awful lot of things and we're committed to do that."
The Sanitation Department has bar codes on the sides of its trucks that take people to an ad about recycling.
And Parks Commissioner Adrian Benepe said he'll look into using bar codes to help people book playing time at tennis courts or ball fields. He also suggested bar codes near statues to give people information about sculptors.
"We're always exploring new technology," Benepe said. "The question is what technology do you invest in that won't be outmoded in six months?"

Deciphering the Fiscal Policy

The biggest fiscal expenditure programme in the history of the world is underway. Sweeping across 4 continents and pulling down political barriers, this swift, responsive and coordinated effort by governments around the world have led us to diverge away from what could have been the ‘greatest’ depression. Internationally coordinated efforts of governments have defended us from fallacies of the past; having taken lessens from Dr Keynes whose medicine of rapid and expansive fiscal expenditure has indeed worked again.

Even after the death of Keynes his legacy continues, along with it the debate surrounding his bequest. Many economists still doubt till date his policy of high government expenditure and especially in light of today’s already inflated fiscal deficits. Keynes had suggested that the government should take charge of the expenditure in times of collapse and forget the increasing deficit, which will take care on its own, once the economy is back on track.

The situation which government’s face today is indeed unprecedented. 

The success of the fiscal stimulus in the past is a motivation to spend, but the danger of over burdening itself with debt is more real and feasible this time around. 

Rather then bringing in investments, it might just scare away private investment by increasing interest rates and a subsequent lower sovereign credit rating. Currently it is expected that the stimulus package would run the economy and sustain markets till the end of next year. Governments are prudent to early withdrawal calls, with the Japanese crisis still in fresh memory.

Here is an idea of how much governments need to watch out next year as well, in the recovery stage.

Country	Fiscal Deficit (as % of GDP)
USA	9.70%
UK	13.30%
Japan	10.50%
India	8.40%
China	4.30%
Brazil	1.30%
Russia	5%

          Source: IMF Estimates for 2010

Thus it would make a good case to explain that why on earth, governments are willing to take so much of risk and are pumping in so much of money and if it would ever reach the desired targets.

For me an easy way to understand this would be to break down the decision making involving fiscal stimulus and focussing on different regions and nations to derive more sense from their decisions. Thus in simple lay man terms, I breakdown to what are the options available to the governments, why the fiscal stimulus has been so dominant this time, why some economists are sceptical about it and the dilemma of timing of withdrawal of taxpayers support.

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Liquidity

Liquidity

“Words pay no debts.” – Shakespeare: Troilus and Cressida, Act II

While solvency addressed the broader concept of a country’s ability to service its debts, liquidity targets the more immediate cost of funds to retire or roll-over its obligations. The European debt issues over the past year have brought increased scrutiny to the near-term liquidity of sovereigns. The markets had always assumed that developed economies would have ready short-term access to capital and thus that roll-over risk was minimal. As Greece showed (and Portugal may, too, in Q1 2011) this is far from the case. A country with a huge gross public debt/GDP burden may have a more manageable near-term outlook than a neighbor with a smaller burden if its debt has long maturities or low effective interest rates. Additionally, as the case of Ireland has clearly shown (see Chart 1), a country with seemingly-sound solvency indicators can be driven to crisis by perceptions of near-term liquidity problems.

Short-term debt

Short-term external debt (maturities of less than one year) is vulnerable to deteriorating market conditions, and a high proportion of short-term debt poses a liquidity risk that can quickly become unsustainable. Usually, short-term external debt is issued by the private sector and used frequently in matters of trade finance. However, this form of financing is often used for speculative advantage, with foreign purchasers holding such debt and acting on exchange-rate movements to churn significant returns. In the case of Thailand in 1997, a sharp accumulation of domestically-issued short-term debt and rising speculative purchasing from overseas spiraled beyond sustainable levels. When the currency fell, foreign interests pulled out of the market and the economy came crashing down along with most of southeast Asia.
This was also the key problem for Greece earlier this year. Not only did the public sector debt burden turn out to be far higher than government data had revealed, and with much of that debt held by nonresidents, but an astonishingly-high proportion was short-term debt. As concerns about Greece’s fiscal situation mounted earlier this year, so did the sovereign’s funding costs, making it prohibitively expensive to roll-over the short-term debt coming due in the spring. Hence the IMF/EU bailout plan announced in early May.

Interest rates

Rising interest rates are particularly problematic when a country has an uncomfortably large ratio of short-dated debt, as those rates represent additional costs in rolling over debt. As the country builds up further debt, the market begins charging higher rates to cover the additional risk. This can create a vicious circle of rising debts and servicing costs, and if left unchecked can trigger a debt crisis.
As it became increasingly evident in the spring that Greece’s debt problems were far greater than had been previously assumed, Greek interest rates broke with their German counterparts and rose to represent a significant risk premium. Despite the two countries sharing the same currency and monetary policy system, one-year debt in Greece carried a 350-basis point mark-up above Germany and the major Euro-zone economies.
Publicly held U.S. debt exploded to $9 trillion in 2010 (62% debt-GDP ratio) from $5.8 trillion in 2008 (40% debt-GDP ratio). The surge in debt was a result of lower tax revenues and higher federal spending related to the severe recession and financial crisis. The low interest rate environment held down interest costs to $147 billion or 1.4% of GDP, one of the lowest as a share of GDP in the entire decade. However, according to the Congressional Budget Office's estimate, interest costs are projected to climb to $800 billion or 3.4% of GDP by 2020 due to the combination of rising debt and higher interest rates.
Looking into 2011, one of the key issues facing many of the European sovereigns is that rolling over previously-sustainable debts may become prohibitively expensive as market anxiety causes interest rates to climb. This interest rate burden would weigh on both sovereign and bank debt needing to be refinanced.

Average Maturity

Similar to the effective interest rate, monitoring trends in the maturity profile of public debt is essential. This is a measure that can provide particular color to the solvency measures as a nation could carry a heavy gross debt burden, but have a very beneficial maturity structure, which is something you won’t see in most comparisons of countries by public debt. Again, this is a particularly important trend for emerging economies as being able to extend the maturity of debt is a sign of both increased financial development as well as increasingly strong credibility. For example, Brazil’s average debt maturity in 2006 was 3.5 years and is expected to come in around 5.4 years in 2010.
In the early part of the financial crisis there was a decline in average public debt maturity in the advanced economies to cater to risk preferences of investors. As market conditions have stabilized and risk appetite has changed, governments are able to extend maturities of debt.

Market Perceptions

The sovereign credit default swaps (CDS) market reveals whether market sentiment toward a nation’s debt situation is bullish or bearish. In general, a CDS is a derivative which transfers the risk of a bond default. The buyer of a credit swap receives credit protection and the seller of the swap guarantees the credit worthiness of the product. The buyer of the CDS is compensated in the event of a bond default or restructuring. The buyer of a CDS contract pays a premium for protection. In sum, a CDS is an insurance policy. The terminology used in this market runs as follows: A 0.01 percentage point rise in a five-year contract indicates a $1,000 increase in the annual cost of insuring $10 million of debt for five years. A rising sovereign CDS quote implies that the cost of insurance has risen and the market places a higher risk of default for the nation in question. The chart below indicates recent movements in the cost of buying insurance for sovereign debt, and clearly illustrates the extent to which market perceptions have shifted regarding the “peripheral” Euro-zone members compared with Germany. At the beginning of 2008 CDS rates for some of the riskiest Euro-zone countries were only 15 basis points above the German CDS rate (when risks in the ‘zone were not differentiated), but that gap has since widened to over 220 basis points for Spain and 1,025 points for Greece. The US, however, has remained virtually unmoved at a level bordering on insignificant.

Chart 4

The Economy and the Banks

“If you would know the value of money, go and try to borrow some.” – Benjamin Franklin, Poor Richard's Almanack (1758)

The final set of metrics to consider is whether an economy can cope with a higher debt burden and with a period of fiscal austerity to get debts under control. Does the government have room to raise taxes if needed? Does the economy have the ability to generate domestic savings at a time of rising government debt levels? Getting sovereign debt under control can also be more difficult if the debt increase was sudden and recent, implying the need to impose harsh fiscal austerity measures (e.g., Ireland).

GDP Growth and Fiscal deficits

The budget deficit of a nation is the amount by which the government’s expenditures exceed its outlays during a specified period of time, usually one year. National debt is a government’s total indebtedness at a moment in time and is the result of previous deficits. As an example, Italy’s gross public debt/GDP ratio is far higher than Spain’s, but the latter country’s debt increase has been recent whereas Italy’s debt level has been over 100% of GDP for many years. Italy does not need a major fiscal consolidation effort to stabilize its debt ratio. In addition, privately held debt levels in Italy are among the lowest in the Euro-zone, there is less concern about the state of its banking system, and the economy is not struggling to recover from the collapse of a credit or housing market bubble.

Table 2

Those sovereigns that have suffered a sharp increase in the public debt burden over the past two years will need to generate significant annual public sector surpluses over an extended number of years in order to first stabilize and then reduce that debt burden relative to GDP. Aside from the political difficulties of doing this, the very fiscal austerity measures needed to cut the annual deficit (and to boost private savings) are also likely to shrink nominal GDP – so making a reduction in the debt ratio even harder.

Banks and Contingent liabilities

As we have seen recently in Ireland, contingent liabilities can greatly affect total debt ratios should an unforeseen event occur. The IMF describes these liabilities as ones that “may affect the financial performance or position of the general government sector depending on the occurrence or nonoccurrence of one or more future events.” These exposures are often not included with the traditional reporting of debt, despite the fact that the sovereign could be the ultimate guarantor of the liability.
In September 2008, the Federal National Mortgage Association (Fannie Mae) and Federal Home loan Mortgage Corporation (Freddie Mac) were nationalized and the U.S. Treasury took ownership of these entities. The associated outlays of these entities are part of the federal budget now and are a contributory factor for a widening of the budget deficit and consequently raising the level of public debt. This is an example of unexpected contingent liabilities that modify the prevailing structure of public debt.
As we head into 2011, investors are focused on one particular source of contingent liability for many EU sovereigns, namely that they may have to follow Ireland in taking the obligations of troubled banks onto the public books. EU banking sector liabilities are much larger than government debt levels. According to the IIF, Ireland is in a league of its own, with total bank liabilities at roughly 9.5 times annual GDP, but the EU average is still high at about 4 times GDP. Obviously, not all of these liabilities are likely to turn non-performing but the potential for a sharp increase in contingent liabilities emanating from the banking sector is particularly high for a country such as Spain, which suffered the double-whammy of a construction and housing market collapse along with the Europe-wide recession. Under “normal” circumstances, the contingent liabilities posed by Spain’s small, regional lending institutions – the cajas – would not be a huge burden on the sovereign, and the two large, systemically important international banks do not appear to carry elevated insolvency risks. Nevertheless, market tensions are boosting funding costs, adding to the problems of those banks that are stressed. According to analysis carried out recently by Royal Bank of Scotland, it is “difficult to come up with a scenario where the Spanish bailout of its banking system costs more than 10% of GDP.” Even a 10% increase in Spain’s public debt burden next year would not break its back given that the starting point of the sovereign’s debt ratios were not particularly burdensome. The risk for Spain is that a short-term liquidity problem for the banking sector – perhaps triggered by prohibitively high market rates or by lack of access to counterparties – could turn into a contingent liability problem for the sovereign.
In assessing the risk from banking sector liabilities, it is also important to take into account the size of the banking sector relative to the size of economy. The highest risks stem from smaller economies with fewer resources to call upon when their banking sectors get into trouble. Remember the extreme example of Iceland, whose sovereign was overwhelmed by bank debt burdens and couldn’t guarantee them. This is why Portugal ranks higher on investors’ list of troubled countries than the aforementioned Spain, with an economy that’s only about 15% the size of its much larger neighbor. Portugal’s banks rely on external and official sources to finance up to 40% of their assets (IIF data), leaving them at greater risk of liquidity problems.
The level of domestic private sector debt also has an impact on potential contingent liability risk. High levels of household debt, for example, exacerbate the impact of a housing market collapse and add pressure on domestic banks, boosting their non-performing loan levels. Also, paying down high levels of debt during a recession is an added constraint on the economic growth outlook, further complicating the picture for a government trying to reduce its deficit/GDP ratio.

Issues for 2011

By and large, 2010 was the year of consolidation of a lopsided global economic recovery. 2011 is likely to be the year of sovereign debt challenges. At the worst there is a risk that an OECD sovereign – most likely Greece – ends up with some form of debt restructuring. The very fact that this is a serious risk calls into question the basic assumption that OECD sovereign interest rates are a benchmark against which to price other risks. The realization that things have changed has caused even German rates to edge upward in recent weeks. Although it is the weaker European credits, both sovereign and private sector, that are most at risk from much wider spreads on their borrowings, there is the potential for this shift in assumptions to affect the structure of the market pricing of all debts in 2011. And if default by a sovereign is no longer inconceivable, markets will begin to re-think what is considered a sustainable level of government debt – for emerging markets as well as major ones.
The fiscal barometer of the global economy in 2010 indicates that fiscal deficits have dropped in the emerging economies of Asia, Latin America and Europe. At the same, although fiscal deficits in the advanced economies show a declining trend, a few appear to have posted wider fiscal deficits in 2010, which will further boost their public debt ratios heading into 2011. Table 2 indicates that public debt has risen to prohibitive levels among the advanced nations and will remain at these elevated levels in the near term. In light of this expectation, we have compiled a list of likely trends for 2011 which are related to public debt issues.

• Declining yields of government bonds of advanced nations was the predominant theme of 2010, which was partly reversed in the closing weeks of the year. The higher bond yields seen in December are mostly likely to prevail in 2011 for disparate reasons.

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• Higher U.S. government bond yields in recent weeks have been driven by a combination of forces: the bullish nature of economic reports, passage of the Obama-McConnell tax compromise, the second round of quantitative easing underway, and the likely increased supply of government securities arising from the tax-cut plan. Large swings in bond yields should not be surprising in 2011.
• Recent movements of credit default swaps suggest that market participants have given the United States more wiggle room to sort out public debt issues. Markets will be sensitive to deficit reduction plans of the United States to assess the long-term debt sustainability.
• Europe will remain under a cloud, with doubts about the pace of economic growth and the wide reach of contingent liabilities influencing market sentiment about the Euro-zone.
• There is a perennial risk that an event in Europe such as an election, a particularly-expensive government bond issue, or headlines about problems at a bank, could trigger a liquidity crisis that turns into something worse if not checked in time. The most likely scenario is that the EU will continue to do what it has always done – a messy muddling-through that counters any near-tern liquidity woes but sidesteps tackling longer-term solvency issues.
• Concerns about the costs of keeping the Euro-zone intact are likely to drive Germany’s borrowing rates higher in 2011 vis-à-vis 2010. Markets will test the Euro-zone’s willingness and actions to prevent the collapse of the euro.
• Ongoing moves to create a “permanent” bailout mechanism for the EU carry the seeds of a more profound re-thinking of fiscal policy and sovereign relations, particularly among the 16 members (soon to be 17) of the Euro-zone.
• Emerging markets are being seen in a very positive light. An upset of this apple cart could occur if China commits policy mistakes that could derail economic growth.

Gross external debt/GDP

Gross external debt/GDP

This solvency indicator is often confused with the public debt ratio, but gross external debt/GDP is distinct on two key criteria. First, it includes both private and public debt – individuals and private firms as well as the public sector, with the private debt stock often being the larger category in more developed economies. Second, it only considers all liabilities, principal and interest owed to nonresidents (private foreign banks, other governments and multilateral institutions) by residents of a country. This ratio is useful in revealing how much of a country’s debt is exposed to cross-border risk and particularly currency fluctuation. The currency issue is not as important for US entities that nearly exclusively issue debt in US dollars. However, the majority of countries issue at least some debt in US dollars, yen, or euros, particularly emerging and developing economies. This adds a layer of currency risk to their profiles, which can be a particularly volatile category during times of crisis.

Table 1

While euro-denominated Euro-zone debts were once assumed to be free of currency risk within the ‘zone, it is dawning on investors that risks vary significantly across the Euro-zone. German debt and Greek debt, while issued in the same currency and from the same economic bloc, each possess distinct risk factors. Complicating the Euro-zone situation is very significant levels of cross-border holding of sovereign and banking debt by Euro-zone and wider-EU banks. According to the Institute of International Finance (IIF), for most of the sixteen Euro-zone sovereigns, non-domestic investors hold more than 50% of the outstanding government debt. Some 65% of Greek government debt is held by non-residents in the rest of the Euro-zone and, according to Bureau of International Statistics data, the largest creditors to Irish public- and private-sector debt are banks based in the UK and Germany.
External debt is particularly important when assessing the debt stocks in Latin America, Africa and other emerging economies where a history of poor credibility precluded countries from issuing international debt in their home currency. As countries develop their capital markets they are dependent on borrowing from outside sources, and currency risk becomes one of the most important factors weighing on overall external debt ratios.

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Japan is an example of a developed economy with a high public sector debt ratio but low external debt relative to GDP – i.e., most of its public sector debt is domestically held. With the bulk of the nation’s public and private debt denominated in yen, repayment is not held hostage to the exchange rate, but rather to the Bank of Japan. This minimizes the risk of a public debt default as the central bank could always print more yen as a last resort. And as the debt is mainly domestically held, the country would not experience a massive outflow of funds that could destabilize the external balances. These factors offer Japan some protection from a debt crisis, setting it apart from countries with severe cross-border risk.

Deciphering Debt

Editor's note: Click any chart in this editorial to enlarge in a new tab/window.
Over the past year we have received many questions about Europe’s debt woes and their implications for the global outlook. As the year progressed it became clear that there is a fair bit of confusion regarding national debt levels and determining which countries are most vulnerable and why. Many wonder why Ireland is facing a crisis when its public sector debt stands at less than 100% of GDP, whereas Japan garners no headlines even as its debt level approaches 200% of GDP. Headline writers tend to focus on the ratio of gross public sector debt to GDP but other metrics, while not as media-friendly, are important and necessary to understand the nuances and ramifications of indebtedness. Unfortunately, 2011 is likely to raise more issues about debt, with periodic market panics about debt sustainability and bailouts. We therefore decided to take a step back and offer this primer on the issue of debt – specifically the various measures and the roles they play in determining a country’s risk of facing some form of debt-related crisis. Metrics to assess indebtedness of nations are classified as solvency and liquidity measures, which will each be discussed in depth. We will also touch on the special topic of the banking sector and its relation to public debt, followed with comments about how market perceptions play into this situation. The final section lists our view of global public-debt-related challenges in 2011.

Solvency

“A national debt, if it is not excessive, will be to us a national blessing.” – Alexander Hamilton: Letter to Robert Morris, April 30, 1781

The defining element in determining the risk of debt is the issuer’s solvency – its ability to pay what it owes. The most commonly cited measures of a country’s long-term solvency focus on the health of public finances and have gained in prominence recently thanks to the ongoing European crisis, but they are only part of the picture. Special care must be taken when comparing various countries’ solvency ratios (i.e. “Look! The US and Portugal have similar debt-to-GDP ratios! We’re doomed!”), as they are often calculated differently and may even unwittingly compare dissimilar measures altogether. This often occurs when the term “debt-to-GDP” does not specify between gross and net – a vast difference in some cases. Developed economies’ ratios are popularly expressed in net terms, while developing countries use gross terms, but this heuristic often falls victim to expedience.

Gross Public Debt

Public sector debt is a part of modern financial systems, and in moderation can be a boon for national development. The widest definition of government liabilities – gross public debt – captures all principal and interest payments due. As is true of all metrics, the gross public debt ratio (debt to GDP) provides only a partial indicator of sovereign solvency – a crude indicator of long-term national solvency. However, it does not consider debt relative to actual government revenues (the capacity to repay), or the amount and quality of public assets (the capacity to offset debt). This anomaly makes countries with low levels of government revenues appear more solvent than reality might suggest.

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Net public debt is gross public debt minus the assets held by the government (calculations differ slightly from government to government). The assets can include debt securities (national, regional or provincial) held by the government, other agency bonds, and cash, but do not account for non-financial assets
Comparing the net debt level to GDP suffers from the same shortcomings as the previous measure. While in many ways net debt is a superior measure of indebtedness, it is also subject to misinterpretation. For example, while the US is forecast to end 2010 with gross public debt of 91.4% of GDP and net debt of 62.3% of GDP, a difference of $4.3 trillion, there is no guarantee that those assets can indeed offset debts. When countries experience a financial crisis, their publicly-held assets may not be able to be liquidated or may only sell at a significant discount, thus diminishing any capacity to balance the ledgers at a time when it is needed most. In this regard, gross debt is the most consistent indicator of a sovereign’s obligations, though its shortcomings are noteworthy.
The flip-side of the public debt/GDP ratio is that a lower figure suggests a country has more room to maneuver in countering or offsetting major economic shocks. When the global economic crisis came to a boil in late-2008 and governments compiled massive stimulus packages and incurred large budget deficits, the markets viewed favorably the less-indebted countries with plenty of wiggle-room while punishing financially burdened countries falling deeper into the red. South Korea and China, large export economies with debt/GDP ratios below 30% at the time, received praise for the deficits they ran and the additional debt they issued to fight off recession. Talk of more debt in neighboring Japan, however, with a debt/GDP ratio at a staggering 168% of GDP in 2008, only increased fears that the country would push itself into a debt trap and financial ruin.

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