Deciphering Debt

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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.

Chart 1

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.

Chart 2