The Sovereign Debt Danger Zone

In perusing various financial websites, I stumbled on this one graphic that perfectly captures the current state of the global economy and how it has entered the sovereign debt danger zone:

If you are having difficulty understanding the graphic, it looks at the level of public debt as a percentage of GDP versus nominal (i.e. not corrected for inflation) GDP growth levels for many of the world's advanced economies.  The graphic compares the average pre-Great Recession (aka "crisis") sovereign debt as a percentage of GDP for the years between 1995 and 2006 plotted against nominal year-over-year growth in GDP and then compares that the same data over the last two quarters.  In all cases with the exception of Japan which has a very small increase in nominal economic growth, you can see that nominal GDP growth has decelerated and debt levels have risen.  This pushes all but one of the data points upwards and to the left, in the direction of debt danger. 

What this tells us is that central bank policies since the Great Recession have had two key results:

1.) the monetary policies have led to a very worrying increase in the level of sovereign debt as governments lined up at the trough to avail themselves of ultra-cheap credit.  In some cases, this increase was very significant; pushing debt-to-GDP levels above the 100 percent mark. 

2.)  the monetary policies have been quite ineffective at prodding the economy back to the growth levels experienced in the decade prior to the Great Recession.

What is particularly concerning is that, as sovereign debt levels rise, it becomes increasingly difficult for governments to stimulate their economies during an economic contraction.  Given that we are mathematically overdue for a recession, this graphic shows us that the world's central bankers will have to become even more creative if they hope to lift the global economy out of another downturn, creativity that will surely result in even more unintended and negative consequences.

A Long and Painful History of Sovereign Debt Default

A paper by Michael Tomz of Stanford University and Mark Wright of the Federal Reserve Bank of Chicago looks at the long history of sovereign debt and the risk and repercussions of default.  

The authors begin by noting that sovereign debt was one of the first financial assets that was traded and that this form of borrowing has gone on for hundreds of years.  One of the ongoing problems with sovereign debt is that, unlike private debt, repayment of the borrowed amount is difficult to enforce since there are very few government assets that can be "attached" (i.e. assets that can be frozen to be sold by creditors) in foreign jurisdictions.

How much sovereign debt is there?  Here is a chart showing the history of the face value of all securities and the percentage of those securities that are sovereign debt on the London Stock Exchange, one of the world's largest capital markets for most of the 19th and early 20th centuries:

By 2010, sovereign debt accounted for 19 percent of global financial assets.  Right now, the Economist's Global Debt Clock shows that the total global public debt is just over $50.253 trillion with the world's developed economies having the highest overall debt levels as shown on this map:

First, let’s look at the two greatest risks to countries issuing sovereign debt:

1.) Borrowing funds using bonds with short maturity dates.  Nations that have a high percentage of their debt in short-term bonds are subject to "roll-over" crises where the government is unable to issue new loans to repay maturing ones.  Recent examples include Mexico, Indonesia, Korea, Thailand, Russian and Brazil in the 1990s.

2.) Borrowing funds using foreign currencies.  Between 1979 and 2006, 100 developing countries issued long-term debt in 75 different currencies.  In 2000, almost 70 percent of all debt was denominated in U.S. dollars and 90 percent was issued in USD, Yen, Euros and Deutschmarks. 

Now, let’s briefly answer a series of questions about sovereign debt.

How often do countries default on their debt?  Here is a graph showing the number of defaults from 1820 to 2010 along with the total proportion of those defaulting on their debt in black:

In 176 sovereign entities between 1820 and the present, 80 percent had outstanding debt.  Over that time frame, there were 251 defaults by 107 distinct entities.  The most frequent defaulters were Ecuador, Mexico, Uruguay and Venezuela, each experiencing 8 distinct default episodes.   Ecuador and Honduras have spent more than 120 years in default in total.  Greece has been in default for more than 90 years over the 200 year sample period.  The world's largest default was Greece in 2012.

The solid line on the graph reveals the four episodes in which at least 30 percent of the world's debtor nations have been in default, in other words, a global debt default crisis.  The most recent global debt crisis took place in the 1980s, the first major default crisis since the Great Depression of the 1920s and 1930s.  You will notice that the number of sovereign defaults hit a new record during the debt crisis of the 1980s with as many as 27 nations defaulting in a given year.

What is the probability of a debt default?  The database used for this study suggests that the unconditional probability of a borrowing nation defaulting on its debt is 1.8 percent.  

How long do defaults last?  The mean length of a default across the nearly 200 year sample is 9.9 years and, since the 1970s, is 7.8 years.  The median of all 251 defaults over the study period was 6.5 years.

How much do creditors tend to lose in a default?  Market haircuts (which compares the market value of the settlement to the face value of the defaulted debt) average between 38 and 50 percent with up to an 87 percent haircut for some highly indebted poor nations.

Sadly, many nations find that their debt-to-GDP ratio does not improve after they default on their debt.  On average, a median country ends up with a debt-to-GDP ratio that is 5 percentage points higher in the year of the default and this increase is largest for low income nations.

The debt crisis in Europe seems to be unending and unresolvable, a fact that is not terribly surprising when one puts it into the context of the world’s sovereign debt history.  On top of the ongoing Euro-crisis, we have yet to feel the full brunt of bond market tremors from the seemingly more creditworthy nations of the world including the United States, Japan and the United Kingdom, all of which are experiencing fiscal problems of their own. 

Sovereign Debt - What Is A Safe Haven?

Updated June 29th, 2012


Over the past year, many nations, particularly those in Europe, have seen the yields on their sovereign bonds skyrocket to levels not seen for decades in some cases.  Since bond yields rise as bond prices fall, these higher yields are a result of dropping prices for bonds as demand for riskier national debt has decreased.  Here is a prime example showing what has happened to the yield for Italy's debt, noting that it is well above its five year average:

As the third-most indebted nation in the world in nominal terms with nearly €2 trillion in debt, it is no wonder that investors in Italy's massive sea of bonds are more than a bit nervous.

In the April 2012 edition of the Global Financial Stability Report published by the IMF, economists look at the concept of the sustainability of sovereign debt noting that the recent financial crisis has led to the idea that no asset (i.e. no paper asset) can be viewed as truly safe.  This is particularly worrisome for investors as previously riskless assets including U.S. Treasuries have experienced ratings downgrades.  The very notion of "risklessness" no longer applies, particularly as public trust in the ratings agencies has declined since the Great Recession.  Actually, no investment is viewed as completely without risk, there is always a risk that default could occur in any bond asset, however, for most nations that is very low since national governments have nearly unfettered access to the money that taxpayers have in their wallets.

Here is a graphic showing how the global financial crisis led to greater differentiation in the prices of sovereign debt as investors looked for safety:

You'll notice that prior to the middle of 2008, the yield on 10 year bonds for all 13 countries in the sample fell within a very narrow band.  This changed as the Great Recession set in with Greece being the first nation to break free of the band in late 2008.  This was followed by Portugal in late 2009 and by Italy, Spain and Belgium.  As yields rose in these five nations, they continued to fall in the remainder of the sample until Austria and France noted a slight rise in yield in late 2011.  This was not the intention of the original European Union pact; since all nations had the same currency, all were to be viewed as sharing the same sovereign debt rating.  As well, what never ceases to amaze me is how the yield on U.S. Treasuries is at or near historical lows; this for a nation with nearly $16 trillion in debt.

So-called safe assets (government bonds) are very important to the world's financial marketplace since they are viewed as the most reliable and non-volatile store of value allowing them to be used as collateral since their price has historically been relatively stable.  Such is not the case now, largely because the actions of central banks including the Bank of England, the Federal Reserve and the European Central Bank has propped up the prices in some cases by artificially increasing demand for bonds (that is, outside of the normal marketplace demand level), resulting in decades-long lows in yield and record high central bank balance sheets.  

Let's take a look at the safety level of various OECD nation's sovereign debt.  Here is a chart showing how varied "safety" is across the Eurozone and selected OECD nations as rated by S&P and how those ratings are now the most variable that they have been in decades:

Differentiation in safety as measured by S&P is more pronounced than in previous years with southern Europe and Ireland having historically low ratings and downgrades in countries that previously had AAA ratings including France, Austria and the United States.

Here are two pie charts showing the world's supply of marketable potentially safe assets ($74.4 trillion worth):

As of the end of 2011, AAA-rated and AA-rated OECD government debt accounted for $33 trillion or 45 percent of the world's total supply of safe assets.  As the European debt crisis has unwound, the supply of sovereign debt that is viewed as a safe asset has fallen, resulting in the removal of $9 trillion of safe assets from the world's inventory.  This represents about 16 percent of the total world's supply.  This will result in distortions within the bond markets since the supply of safe sovereign assets is falling at the same time as the demand is rising, resulting in price distortion to the upside and yield distortion to the downside.  According to the IMF, this supply-demand imbalance could have the unintended consequence of forcing investors to settle for assets that have a higher risk profile than what they would normally be comfortable with.

Here is a chart showing the likelihood of default of various ratings interpretations over a five year period:

You can see that, as investors climb down the ratings ladder, the risk of default rises, sometimes to uncomfortable levels.  As the flight to so-called safe government bond assets rises and the supply declines, investors will face difficult decisions about where they should invest their hard-earned money to both preserve capital and maximize return, issues that will be increasingly difficult as the world's level of sovereign debt rises.

Fiscal Space and Fiscal Path - How long before sovereign debt reaches crisis levels?

The Comeback America Initiative (CAI), a non-partisan, non-profit organization that is dedicated to fostering discussions around fiscal challenges and solutions.  CAI recently released the findings of its Sovereign Fiscal Responsibility Index (SFRI), a "new fiscal indicator that incorporates a wide range of fiscal, economic and political factors into ranking a country’s fiscal responsibility and sustainability."  This Index provides an insight into the fiscal sustainability of countries around the world by incorporating a wide range of important factors.  The SFRI is the result of a Master's Thesis completed by a team of Stanford University graduate students under the guidance of David Walker, former Comptroller General of the United States.  The index was created to illustrate the current fiscal standing of the United States, where it is headed and how the United States compares to other nations around the world in the area of fiscal responsibility and sustainability.

Here's a quote from one of the team members:

"For many years, people have argued that U.S. government debt is the safest investment out there. Similar arguments were used until 2008 for AAA companies and home prices. We need to understand as a country that while one cannot predict a fiscal crisis, it could be just a few years away if we do not act soon. I was stunned as our team conducted our analysis to find that in only two to three years, the U.S. overall fiscal score will be the same as Ireland or Portugal today.

On the other hand, to see the progress of Australia, New Zealand and emerging markets like Brazil and Mexico was great. Through disciplined spending and legal reforms, these countries have put themselves on solid ground. It shows that countries can change their future through political will. I hope that the United States acts before we hit a painful crisis, rather than after."

The SFRI was constructed by defining each country's sovereign debt level and how much debt that particular country could safely manage by incorporating both qualitative and quantitative metrics.  The results of the SFRI show how countries compare in fiscal responsibility and sustainability.

The SFRI defines fiscal responsibility as a measure of government controls on spending and debt level management.  Three factors are considered; a government's current debt level, the sustainability of that debt over time and the degree of transparency and accountability for their fiscal decisions.  The SFRI also considers the existence of institutions, regulations, procedures and enforcement that regulate the budget process.

Once the SFRI is derived from this information, it has three major components; fiscal space, fiscal path and fiscal governance.  For the purpose of this posting, I'm just going to look at two of these components, fiscal space since it is a really fascinating concept that I've not seen before and fiscal path.  I may post on the overall rankings of each country in the future but including that data in this posting made for a very long read.

Let’s deal with fiscal space first.  Fiscal space is basically answering the question "how much debt is too much?".  It represents the amount of additional debt that a given nation can issue before the level of debt creates a crisis, in other words, the difference between the current debt and the debt crisis level which is termed the "debt ceiling".  The concept of fiscal space is an estimate rather than a hard number since each nation's economy has varied ability to sustain high levels of debt.  The researchers used a term "weighted-average debt level" which consists of gross sovereign debt, intra-governmental debt holdings such as social security, sub-national government debt and public debt held by foreigners to level the playing field between nations so they could get a more complete look at the total amount of a country's debt.  Their overall analysis of the nations in the study show that nations should maintain a space of at least 50 percent of GDP between their debt level and their debt ceiling to reduce the risk of a fiscal crisis.  Nations such as Japan, Ireland, Portugal and Greece all have current fiscal space that is less than 50 percent of GDP.

Here is a bar graph showing the fiscal space for the nations involved in the study highlighting the 50 percent of GDP danger point:

The nations with the greatest fiscal strength in terms of fiscal space are Chile and China with space of 193.3 percent and 184.9 percent of GDP respectively.  Australia and New Zealand are also in very good shape with space of 168.2 percent and 163.6 percent of GDP respectively.  Canada comes in right in the middle of the pack with fiscal space of 106 percent of GDP.  The United Kingdom is in the bottom third with fiscal space of 90.8 percent of GDP and the United States is in the bottom quartile with fiscal space of 62.4 percent of GDP.  Nations in danger of being overwhelmed by their debt include Japan, Belgium, Ireland, Portugal, Italy, Iceland and Greece.  Many of these nations have been in the news lately because they have or will require restructuring of their sovereign debt. 

Fiscal path is simply a projection of future levels of sovereign debt for a given nation.  Nations with relatively low overall debt today but rapidly rising debt levels may be on a poorer future footing than countries that have high but very slowly rising debt.  By using projections for future government spending from the IMF, the study projects sovereign debt for each year into the future up to the year 2050 and then estimates how many years it will be before a country reaches its debt ceiling.

Here is a bar graph showing the fiscal path for the nations involved in the study:

Many nations have over 40 years of time before they hit their debt ceiling once again noting that the study only projected out to the year 2050.  The nations with the longest fiscal path are those developing nations with the fastest growing economies and those nations that have already implemented fiscal reform that limits government spending.  These include Chile, China, Sweden, Australia, India, Korea and Canada among others.  New Zealand is near the top with 38 years, the United Kingdom comes in at 27 years and the United States comes in at 16 years before these countries reach their debt ceiling.  Several nations hit their debt ceilings very soon, among them Greece (already there), Portugal and Japan both at 5 years, Ireland at 6 years, Italy at 7 years and Belgium at 8 years.

What I find particularly interesting about this study is that so much hinges on GDP growth.  Should the world hit another major economic speed bump (i.e. The Great Recession Part 2), all of these countries will have to take on additional debt in an attempt to stimulate their local economies.  The addition of debt and the coincident shrinking of national economies will work together to shorten the time before many of these nations reach their debt ceilings.

The authors of the study feel that time is of the essence, particularly for the United States.  Their analysis suggests that the United States could well be only three to five years away from a debt crisis like the one that is currently facing the PIIGS nations.  They note that tax levels within the most fiscally secure countries varies widely with Sweden having high rates and Chile having low rates meaning that national fiscal responsibility is not related to a given country's level of tax revenue, a lesson which could be learned by Washington.  Nations, particularly in Europe, where demographic changes are anticipated as baby boomers pass into their expensive years should be reducing deficits sooner rather than later to prevent long term fiscal pain.

Let's hope that at least someone in government reads this report and decides to make positive changes now before we read about additional and even more massive sovereign debt near defaults in the future.