With the recent fall in oil prices, the analysis and rumors have been flying about the government default by oil revenue-dependent nations. Also, there has been a resurgence of prediction of the imminent demise of the Japanese government's finances by its mind-boggling debt ball. Now is an opportune time to review the fundamentals of government defaults, and why they are not nearly as simple as many believe.
Assuming that a nation's government will continue to exist and will attempt to make interest payments on debt in good faith, there are fundamental economic and demographic variables to predicting a government default. Below are six of the primary fundamentals that analysts utilize to evaluate the near to medium-term viability of government debt. While others exist, the below six hit the primary categories.
Current load - The ratio of the government's debt to GDP. This is similar to the proxy for the gross debt to revenue used to analyze the default risk of companies. At a certain point, it does not matter how good the product or service is, there is simply too much debt to service and stay solvent.
Current trajectory - The current and near-term forecast of deficit spending.
Cut/Tax your way out I: Ratio of government spending to GDP. In theory, the higher the level of government spending, the easier it would be to find non-critical services to cut. In reality, many countries with high level of spending would have civil unrest even with minor cuts. However, the theoretical basis remains, and to a certain degree it is practical. Conversely, if spending to GDP is low, there should be ways to close some of the gap with types of taxation that do not result in massive deadweight social losses that strangle the private sector (e.g., Laffer curve).
Cut/Tax your way out II: Deficit / Spending. If a government is relatively close on a percentage basis to its total spend, it is more likely that a mixture of tax and spend policies can close the gap. Closing the gap on a 40% spend with a 25% tax base is going to prove politically difficult to impossible. However, closing 60% spend with a 45% tax base is extremely difficult, yet plausible.
Populate your way out - At a basic level, it is more credible for 100 people to pay off a given debt than 50. Debt risk is evaluated on streams of future payments. If there are few people to produce those future payments, the risk rises. Also, even if per capita GDP is constant, it is politically easier to freeze government spending and grow population than to cut spending on a falling population.
Market confidence - 10 Year Bond Yields. This is a bit of circular reasoning, but if others believe that the bonds are sound, then the bonds are sound and the debt will roll over. If others do not believe that the bonds are sound, then it will be difficult to roll the debts over. If it's difficult to roll the debts over, interest rates will go up. If interest rates go up, more debt will need to be borrowed.
With this framework in mind, examine the table below, which includes a few countries that have a high level of "chatter" on their debt levels.
(Source: tradingeconomics.com)
While the framework does give an idea of the medium-term fiscal health of the entity, its primary use is to act as a launching board to ask additional questions. How is Japan not in default with a debt to GDP of 230%? Why does Italy pay a lower yield than the US? This second level of analysis then takes us into the near-term variables with more qualitative aspects, namely, current access to capital, currency effects, and perception of the propensity to pay. The next two posts will examine the narrative around two extreme cases that seem to defy the fundamentals, but for much different reasons -- Japan and Venezuela.
Assuming that a nation's government will continue to exist and will attempt to make interest payments on debt in good faith, there are fundamental economic and demographic variables to predicting a government default. Below are six of the primary fundamentals that analysts utilize to evaluate the near to medium-term viability of government debt. While others exist, the below six hit the primary categories.
Current load - The ratio of the government's debt to GDP. This is similar to the proxy for the gross debt to revenue used to analyze the default risk of companies. At a certain point, it does not matter how good the product or service is, there is simply too much debt to service and stay solvent.
Current trajectory - The current and near-term forecast of deficit spending.
Cut/Tax your way out I: Ratio of government spending to GDP. In theory, the higher the level of government spending, the easier it would be to find non-critical services to cut. In reality, many countries with high level of spending would have civil unrest even with minor cuts. However, the theoretical basis remains, and to a certain degree it is practical. Conversely, if spending to GDP is low, there should be ways to close some of the gap with types of taxation that do not result in massive deadweight social losses that strangle the private sector (e.g., Laffer curve).
Cut/Tax your way out II: Deficit / Spending. If a government is relatively close on a percentage basis to its total spend, it is more likely that a mixture of tax and spend policies can close the gap. Closing the gap on a 40% spend with a 25% tax base is going to prove politically difficult to impossible. However, closing 60% spend with a 45% tax base is extremely difficult, yet plausible.
Populate your way out - At a basic level, it is more credible for 100 people to pay off a given debt than 50. Debt risk is evaluated on streams of future payments. If there are few people to produce those future payments, the risk rises. Also, even if per capita GDP is constant, it is politically easier to freeze government spending and grow population than to cut spending on a falling population.
Market confidence - 10 Year Bond Yields. This is a bit of circular reasoning, but if others believe that the bonds are sound, then the bonds are sound and the debt will roll over. If others do not believe that the bonds are sound, then it will be difficult to roll the debts over. If it's difficult to roll the debts over, interest rates will go up. If interest rates go up, more debt will need to be borrowed.
With this framework in mind, examine the table below, which includes a few countries that have a high level of "chatter" on their debt levels.
| Type | Variable | Japan | Greece | Italy | Spain | US |
| Load | Gov Debt to GDP, 2013 | 227% | 175% | 133% | 92.1% | 102% |
| Trajectory | Federal Deficit, % GDP, 2013 | -7.6% | -12% | -3% | -6.8% | -2.8% |
| Cut/Tax I | Total Gov Spend / GDP, 2013 | 42% | 52% | 50% | 45% | 42% |
| Cut/Tax II | Fed Deficit / Spend | -53% | -26% | -6% | -18% | -19% |
| Grow | GDP Annual Growth, 2014 | -1.9% | 1.9% | -0.5% | 1.6% | 2.4% |
| Populate | Population 5 year CAGR | -0.1% | -0.2% | 0.4% | 0.2% | 0.7% |
| Market | Bond 10Y, Dec 2014 | 0.4% | 7.3% | 2.0% | 1.8% | 2.3% |
While the framework does give an idea of the medium-term fiscal health of the entity, its primary use is to act as a launching board to ask additional questions. How is Japan not in default with a debt to GDP of 230%? Why does Italy pay a lower yield than the US? This second level of analysis then takes us into the near-term variables with more qualitative aspects, namely, current access to capital, currency effects, and perception of the propensity to pay. The next two posts will examine the narrative around two extreme cases that seem to defy the fundamentals, but for much different reasons -- Japan and Venezuela.
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