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:
||Fundamental Weight > Cap Weight by more than 100%
||Fundamental Weight > Cap Weight by more than 25%
||Fundamental Weight approximately equal to Cap Weight
||Cap Weight > Fundamental Weight by more than 25%
||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.