Tuesday, October 1, 2013

Not All Debt is Created Equal

Today is Day 1 of the US Government shutdown.  In spite of the 24/7 media hoopla, this is, in fact, the 16th shutdown of the Federal Government since 1976.  Shutdowns have ranged from 1 to 21 days in duration, with an average of 6.5 and a median of 3 days.

Much has been made of the approach of this event and the supposedly "horrific"implications if we don't borrow more to keep the government open.  Lost in the coverage, however, is the fact that the United States (as well as most other developed countries) have a bigger problem which is no closer to being addressed. It's not a Democratic problem, nor a Republican one.  Not a Labor issue nor a Tory one -- nor a Christian Democrat, nor a Social Democrat, nor a Green Party one.  In fact, it is not a political problem at all.  It is a generational one that will unfortunately be passed along to our children and theirs.  Simply put, governments everywhere have spent AND promised to spend much more than can possibly be generated by their economies without impinging upon growth.  

I have written on this issue at least annually since 2004 and don't wish to rehash the problem in its entirety. However, to quickly review, there are three aspects of any debt situation that one must examine to determine whether a threat exists.  Unfortunately, the most important aspect is the one that is least analyzed.

Certainly, the amount of debt (relative to a country's size) is important.  Below I show the situation of the G-7 countries, plus Spain.  Not one is a shining example of fiscal prudence, though the US is the best of a weak bunch, while Japan and Italy have been most profligate over longer periods of time. 
















Historically, as debt as a percentage of GDP closes in on 90%, it has been observed that a country's subsequent growth slows (the best discussion of this effect is detailed in the book "This Time is Different" by Reinhart and Rogoff.  Subsequent criticism of their findings by a group at the University of Massachusetts, Amherst is oft-quoted to dispute the conclusions of R&R.  However, this criticism tells me more about the critics than R&R - they like to read headlines and executive summaries and not the nitty-gritty.  For those who do read further, it is clear that the R&R conclusions remain valid).

Secondly, how quickly the debt pile growing, the annual fiscal deficit, tells us whether the problem is being addressed or worsening.  Ideally, you  must see the deficit growing more slowly than nominal GDP so that the ratio of debt to GDP can fall.  Here, some countries (Germany, Canada and, oddly, Italy) seem to be making progress, while others appear hopelessly lost (Japan).
















Thirdly, and rarely discussed, is the cost of the debt.  Having lots of debt, but not having to pay any interest on it is an interesting concept.  In fact, this is the state of most countries in the world today.  Historically low borrowing costs have allowed governments (and companies and households) to borrow more and more, without having to pay out greater amounts of their incomes. However, as an economy begins to grow and interest rates rise, debt service costs will likewise rise.  Newly incurred debt (each year's fiscal deficit) as well as previously borrowed amounts that are coming due must all be financed at the new (higher) current rate.  Thus entities with high fiscal deficits and those with shorter maturities are the most vulnerable to having success (a growing economy) short circuit itself.  

Consider for a second the US Government. With a fiscal deficit at over 4% of GDP, a little more than 5% of its total debt pile is priced anew each year (deficit/debt).  In addition, nearly 1/3 of  previously borrowed amounts will mature in the next 18 months, and nearly half in the next three years.  The US is therefore one of the countries most at risk to interest rate movements (along with Canada, Spain and Japan), while only the UK seems to have taken true advantage of the lower interest rate environment, locking in rates for years to come.  

Debt Maturity Profiles for G-7 plus Spain (% of debt maturing within time frame)
             Can            USA           Spain          Japan    Germany      France               Italy             UK
0 - 18 Mos45%32%30%31%25%23%23%11%
18 - 36 Mos17%17%18%14%16%15%14%6%
3 - 5 Yr10%17%16%15%17%14%15%12%
5 - 10 Yr12%22%19%20%26%29%26%23%
+10 Yr16%12%17%20%16%19%22%47%
< 3 Year62%49%48%45%41%38%37%17%


Consider the following two examples.  

The coupon rate on all US government debt that matures in the next 36 months is 1.08%.  If the government wanted to lock in today's low rates for the next ten years, the cost of borrowing would rise to 2.61% on this piece of the debt (the current 10-year yield), while any new debt incurred would also be charged a rate of 2.61%.  Overall annual interest expense would increase by $141 billion under this scenario (assuming interest rates do not rise over this period and deficits run at 4.1% of GDP for the next 3 years).  However, if rates were to normalize (3.92% is the average 10-year bond yield since 2000), interest costs would soar by $243.5 billion.  To put this into perspective, total individual income tax receipts for the US were $1.27 trillion in the 12 months through this August.  Additional debt service costs would equate to 19.2% of individual income taxes currently collected under even a modest increase in interest costs.

The same analysis applied to the United Kingdom reveals a much different outcome.  The coupon rate on all UK government debt that matures in the next 36 months is 3.04%.  If the government wanted to lock in today's low rates for the next ten years, the cost of borrowing would actually FALL to 2.72% on this piece of the debt (the current 10-year yield), while any new debt incurred would also be charged a rate of 2.72%.  Overall annual interest expense would increase by GBP 7.665 billion under this scenario (assuming interest rates do not rise over this period and deficits run at 6.5% of GDP for the next 3 years).  However, if rates were to normalize (4.10% is the average 10-year bond yield since 2000), interest costs would grow by a larger GBP 15.1 billion.  To put this into perspective, total individual income tax receipts for the UK were GBP 194.8 billion in the 12 months through this August.  Additional debt service costs would equate to just 7.75% of individual income and wealth taxes currently collected.

Whilst the study of the size and on-going fiscal situation of countries is important, a potentially even more important aspect - interest rate sensitivity is being ignored.  In a rising rate environment, the United States and a number of other highly levered countries are in danger of suffocating on their own debt, while the UK - a country with a larger debt pile and a bigger fiscal deficit would fare much better.  

So while the US debates the government shut down and the Japanese Abe-nomics and the Germans try to form a new ruling coalition and the Spanish, Greeks, Italians and Portuguese debate austerity versus growth, the bigger picture goes un-addressed to the detriment of future generations nearly everywhere.

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