Debt Be Not Proud*

By Rob Arnott

AUGUST 2010 Read Time: 10 min

We live in a world profoundly addicted to debt-financed consumption. Today, many people, companies, and countries borrow with no evident intention to repay. When the debt comes due, they will replace it with new (and often larger) debt. Kick the can down the road, again and again. But inevitably the road ends abruptly with a wall, much like the ones at the end of a crash testing site.

Debt crash test dummies abound—take, for example, the home buyers during the late U.S. housing bubble or the Iceland banks that borrowed seven times the country’s GDP. These dummies hit their walls a couple of years ago. Soon, many governments—who have thrown money they don’t have, ostensibly borrowing from future generations, into the breach—will approach their walls. Greece recently hit a wall and had to break a lot of promises to its citizens, notably the retirees and prospective retirees from government employment. Greece certainly won’t be the last. The looming sovereign debt crisis will be one of—if not the—defining influences on capital market returns over the next 10 years.

In this issue we explore the relationship between sovereign debt levels and the economic might of the debtor nations. This simple exercise paints a scary picture, particularly for those who rely on cap weighting their government bond market exposure. Bond investors are lenders. Why should we deliberately choose to lend more to those who are most deeply in debt?

Measuring Sovereign Capacity to Service Debt
Measuring a sovereign’s ability to service debt is not easy. There is no direct measure, so we estimate the capacity to service debt by comparing a sovereign’s outstanding debt to its economic size. We measure a country’s economic size using four metrics that proxy the key factors of production in a capitalist economy. Economics literature typically identifies two or three factors of production: capital, labor, and resources (a subsector of capital). Our fourth factor is energy, the most important subsector of resources, which we treat as a separate factor of production, given its importance. We measure these factors as follows:

Capital: GDP is the most widely-used gauge of the size of an economy.
Labor: A nation’s population is the simplest gauge of labor.1
Resources: A nation’s landmass is a very crude gauge of access to resources.2
Energy: The aggregate energy consumption of a nation is a measure of the energy that goes into production of goods and services. One caveat is that this may be sourced externally through petroleum imports.

Building on our Fundamental Index™ work in equities, we calculate country weights for each metric separately, then equally weight each country’s weight in these metrics to arrive at a Research Affiliates Fundamental Index (RAFI™) weight. The fundamental measures of size for various economies are presented in Table 1, color-coded to highlight the relative debt burdens with green signifying the financially sound countries and red signifying the debtor nations.

We believe a country’s ability to service their debt is a function of the debt-level-to-economic-size ratio. Thus, we categorize countries into five categories, from light to heavy debt burden, as follows:

Dark Green   Fundamental Weight > Cap Weight by more than 100%
Light Green   Fundamental Weight > Cap Weight by more than 25%
No Color   Fundamental Weight approximately equal to Cap Weight
Light Red   Cap Weight > Fundamental Weight by more than 25%
Dark Red   Cap Weight > Fundamental Weight by more than 100%

There’s a lot of red ink in the developed economies of the world, and a lot of green in the emerging markets. Many developed countries carry debt—not even counting often vast off-balance-sheet debt—which is out of proportion with their scale in the world economy.

There are pockets of discipline. Australia, Poland, and Slovakia show no “red” at all, meaning that the national debt isn’t 25% above their economic factors of production on any of the four metrics. Canada, Finland, New Zealand, Norway, Slovenia, and Sweden are “out of bounds” on only one of the four measures.3 Collectively these “Prudent Nine” comprise less than 4% of world sovereign bond debt, and yet they encompass 6% of world GDP, 18% of world land mass, and 8% of world RAFI weight.4 Furthermore, several of the “Prudent Nine” have less hidden debt than the G–5. For instance, Australia, New Zealand, Norway, and Sweden largely prefund their future pension obligations.

One might argue that Portugal, Ireland, Italy, Greece, and Spain (derisively—and unfairly—characterized as the PIIGS) are bankrupt states seeking shelter from larger bankrupt states. The collective bond debt of the PIIGS is 2.6 times their collective RAFI weight in the world economy, which arguably relates to their ability to service debt. That’s an acknowledged problem. Isn’t it a sad irony to note that the G–5 economies have a near identical ratio of debt to our ability to service our debts as the so-called PIIGS. And yet we have the temerity to label the Mediterranean rim countries “the PIIGS”?!

The Emerging Markets Debt Conundrum
How precarious are the debt burdens in the emerging economies, economies typically viewed as the most risky in the world? Surprisingly benign! Consider the so-called BRICs.5 As we can see in Table 1, they collectively comprise 22% of world GDP, and yet have only 5% of world bond debt. The G–5 collectively has bond debt six times as large, relative to GDP, as the BRICs.

Even this overstates the debt picture from a global investor’s perspective. The elephant that’s not in the room also bears mention: there are some countries with no net debt. China and Russia have foreign reserves larger than their respective bond debt. Saudi Arabia, Kuwait, Qatar, the Emirates, as well as tax havens like Cayman Islands, Monaco, and Liechtenstein all have no net debt. Most such countries, as with China and India, have no bond debt that any foreign investor would be permitted to buy. These “net creditors” would have a significant collective “fundamental weight” if only there were bonds to buy!

If the BRICs can comfortably support more debt than they carry (based on their GDP, their population, their resources, or their energy consumption), then surely there must be trouble spots in the emerging markets. Indeed, there are some pockets of trouble: Singapore and Taiwan each have a share of world bond markets rivaling their fundamental economic footprint in the world economy.6 According to the United Nations, Singapore and Taiwan are emerging markets, though many experts and some index calculators consider them to be part of the developed world.

Let’s consider the rest of the emerging markets list. Not one of the other 43 emerging markets, which spans all countries that are included in any of the EM debt indexes, has as much debt as any of the G–5 countries, whether measured relative to GDP or relative to the RAFI fundamental economic footprint of these countries. In almost all cases, emerging markets debt is modest relative to their respective ability to carry debt based on the four factors of economic production.

Developed markets account for 62% of the world’s GDP and owe 90% of the world’s sovereign bond debt. The emerging markets collectively produce 38% of the world’s GDP and owe just 10% of world sovereign bond debt. Does hidden debt and off-balance-sheet debt change this picture? Yes. In the wrong direction!7 The emerging markets have, for the most part, little off-balance-sheet debt. The developed economies have, in many instances, vast off-balance-sheet debt.

One might reasonably argue that—absent political risk—emerging markets are collectively more creditworthy than U.S. Treasuries. Which invites a provocative question: when will U.S. Treasuries be priced to offer a “risk premium” (higher yield) than the most stable and solvent sovereign debt that money can buy: Emerging Markets?8

The Ad Council in 1985 released a series of public service announcements with two crash test dummies, Vince and Larry, promoting safety belt usage in automobiles. The tagline of the successful campaign was “You can learn a lot from a dummy… Buckle your safety belt.”9 But have we learned the proper restraints in our investment portfolios from our two most recent debt crash dummies—Greece and the U.S. homeowner? Doubtful. Let’s take a close look at our bond allocations and the index funds that comprise them. The wall is coming. Are we buckled up?

*With apologies to John Donne: “Debt be not proud, though some have called thee / Mighty and dreadful, for thou art not so / For those, whom thou think’st, thou dost overthrow / Die not, poor debt, for yet canst thou kill me.” This issue is an excerpt from a research paper we expect to publish, likely under the same title.

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1. The working age population might be a better gauge. We chose total population because it’s universally available for all countries.
2. We choose to use the square root of land mass in order to avoid grossly rewarding big, sparsely populated countries like Russia, Australia, and Canada, or penalizing small, crowded countries like Hong Kong and Singapore. For midsize countries like Argentina or Germany, this adjustment makes little difference.
3. Interestingly, in each case, the population is the sole outlier; it would appear that their debt is well within bounds on three factors of production: capital, resources, and energy.
4. It’s interesting to note that these countries also largely skated through the “Global Financial Crisis” better than the countries with more debt. They enjoyed average real GDP growth of 1.7% in 2009, double the levels of the G–5 and of the Eurozone.
5. We’ve long found this label puzzling: four countries with almost nothing in common but a shared acronym! Even though China shares borders with Russia and India, the three countries have less in common—culturally, economically, or legally—than essentially any countries on the developed economies list.
6. Singapore has a sovereign wealth fund and Taiwan has gold and foreign currency reserves, in both cases larger than their aggregate debt. So, as with Russia and China, their net debt is nonexistent.
7. See “The 3-D Hurricane: Deficit, Debt, and Demographics,” Fundamentals, November 2009. In the United States, the combination of GSE debt, state and local debt, unfunded pensions and entitlements, all add up to just under $60 trillion, roughly 10 times the official U.S. public debt.
8. On June 30, 2010, the Merrill Lynch USD Emerging Markets Sovereign Plus Index, which spans the dollar-denominated debt of the emerging markets, was priced to yield 6.0%. This was 3% higher than U.S. 10-year Treasuries.
9. Since the ad campaign began in 1985, usage of seatbelts increased from 14% to 79%, saving an estimated 85,000 lives.