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The paper talks about whether or not there is a sustainable debt-to-GDP ratio which can determine when a nation would cross its capacity to service its debts and fall into a debt crisis. Two countries, Greece and Japan, with high debt-to-GDP ratio, have been studied to see what factors have kept Japan away from a debt crisis so far while Greece, with a relatively lower debt to GDP ratio, faced a full-blown crisis last year.
There has been a lot of noise being made about the rising national debt levels in the world recently. The financial crisis of 2008 made many national economies to look to their government and foreign lenders for financial support, which resulted into increased spending, borrowing and in a lot of cases, increasing national debt. And it left some nations and economies in considerably worse debt positions as compared to others.
According to some projections by the economists at the International Monetary Fund the advanced economies' debt levels would soon be so great that they would exceed the value of what they produce in a year.
So, is there a particular debt to GDP ratio which can be termed as sustainable? The short answer is obviously, "No". The long answer is, "It depends".
Greece & Japan: Tale of two Debtors
To understand what makes one country with a high debt-to-GDP ratio fall into a debt crisis while another with an even higher debt-to-GDP ratio maintains the markets' confidence in its ability to service its debt, one can look at Greece and Japan.
Greece has a debt-to-GDP ratio of 127% and last year it required the help of IMF and EU to prevent it from defaulting on its debt. Since the restoration of democracy in 1974, successive Greek governments have run large deficits to finance public sector jobs, pensions, and other social benefits. In fact, Greece's debt-to-GDP ratio has remained above 100%, since 1993. So, Greece had had a problem with its debt for a long time already; the 2008 recession turned its problems into a full-blown crisis. The global financial turmoil of 2008 had a huge impact on Greece. Two of the largest industries of the country, tourism and shipping, were badly hit by it and the revenues fell by 15% in 2009. The fact that they had too many debts maturing at the same time worsened the situation. Greece had 54 billion euros of debt due in 2010 of which more than 20 billion euros were due in the second quarter itself. This raised the market yields for Greek bonds.
Adding fuel to fire was a lot of bad press that Greece was getting regarding its deficit since October 2009. The new government in October 2009 shocked the bond markets and other EU governments by announcing that its 2009 deficit would be 12.5 percent, way too above the 3.7 percent estimated the previous spring. On 12th January 2010, Eurostat, the European Union's statistics arm stated that the Greek government's budget figures were unreliable and could have been falsified to play down the European budget crisis. Then, on 14 February 2010 an article brought out that the government had been misreporting the figures and had paid Goldman Sachs and other banks in 2001 hundreds of millions of dollars for arranging transactions to hide the actual debt levels. This had allowed Greece to spend beyond their means without the EU overseers knowing its actual deficit. Eurostat on April 22 said that the country's 2009 budget deficit was 13.6 percent and not 12.7 percent as was reported earlier following which came the downgrading Greece's credit rating to junk status on April 27 by Standard and Poor .
These happenings led to negative sentiments among investors which in turn worsened the debt situation further. The debt-to-GDP ratio had been high for a long time but the crisis began when the actual debt and deficit figures started coming out. The downgrading of the country's credit rating to junk came as a blow to investors' confidence in the Greek government bonds making it difficult for the government to borrow more to finance its deficit.
Another factor for Greece is that it is heavily dependent on overseas markets for debts with some estimates suggesting that up to 70% of Greek government bonds are held externally. And regardless of all the above mentioned issues, the sustainable debt-to-GDP ratio for Greece would anyway be relatively lower than other countries since it is part of EU and cannot monetize its deficit by issuing currency.
On the other hand, if one looks at Japan, whose debt-to-GDP ratio is hovering near the 200% mark, they will find that there are a lot of fundamental differences with the debt situation in Greece. Japan can monetize its deficit. This implies that it cannot go broke since it can print money. This builds investors' confidence in JGBs. Also about 95% of the total Japanese Government Bonds are held by domestic investors and servicing of debts is managed very smoothly by Japan. This makes Japan's risk of default seem to be much lower than some of the Euro zone countries.
Debt Stability Condition
Is there any way of finding out if a country has a risk of running into a debt crisis? One possible way is to look at whether the country has fallen into a "debt trap" - where the interest rates are higher than the economy's nominal growth rate. A very basic debt formula was first derived by Domar(1944):
where, d* = (D/Y)*, equilibrium value of debt/GDP ratio. (D-> debt; Y->GDP)
prdef = Primary deficit/GDP
sr = Î”H/Y, Seigniorage ratio with Î”H as the change in the stock of money used to finance the deficit.
gY = GDP growth rate
R= Nominal interest rate
For any given prdef, the debt can be stably financed as long as gY > R. If gY < R then there is a debt trap (a burst of seigniorage can still stabilise the debt). Countries cannot live in this trap for long without taking radical economic measures; otherwise interest costs eat up more and more of GDP. Without a sudden burst of growth, governments need to run a primary surplus to get out of the trap - that is, their revenues need to exceed their spending, before interest payments.
The Economist carried out similar calculations in its Feb 2010 edition (Table 1).
Table 1 The Debt Trap
5-year growth rate*
Average Cost of debt**
*Nominal GDP growth based on 2007-11 average
**Average Yield on 2 and 10 year government bonds
Sources: OECD; Financial Times; The Economist
It is important to note that this is a rough-and-ready measure but it does give a good idea of market concern which can be self-fulfilling - the markets' worry about the debt being not serviced is proportional to the cost of the debt, and so the costlier the debt the higher the yield the market would demand.
Clearly, Greece and Ireland appeared to be in the most danger in Feb 2010. But Ireland's troubles were a little over magnified on this ranking. It did so badly because of the depth of its recession. As for Greece, we all know now, that it needed a massive bailout.
Calculation like these can be useful but then we should be careful enough while looking at the results. For e.g., Japan is in a different league than Greece so they probably do not belong on the same chart. The debt trap becomes more troublesome if the loans are mostly held outside the country or are held in foreign currency as then you cannot monetise and print your way out of the debt.
As mentioned before, Japan does not face any serious problems with obtaining and paying its debt because most of the debt is owned by Japanese savers and Japan could, in theory, inflate its way out, due to the debt being denominated in Yen. Also, Japan is helped by large current account and capital account surpluses, meaning that Japanese assets are worth more than their liabilities.
Japan's Future Concerns
We discussed before that Japan is in a relatively better position than Greece as far as its debts are concerned. But this picture of Japan's debt scenario cannot be taken for granted. Japan, so far, has been able to sustain high fiscal deficits, low interest rates and net capital exports majorly as a result of its high private saving rate, which has kept national saving positive. However, the smooth financing of debts might not last for long as the demographic structure of the country is changing, with an increasing number of retirees compared to the workers who save the most.
The savings rate in Japan is on a downward trajectory (Figure 1) and the aging population of Japan would have a lower and lower absorptive capacity for public debts and changes in investors' behaviour could reduce the inflows.
Figure 1 Japan's Saving Rate
With the current low rate of household saving, the increasingly rising deficits and debt, national saving would eventually turn negative. And if there is a shift from deflation to low inflation, as the Japanese government and the central bank want, this would happen sooner rather than later. That would then result in rising real interest rates as the low private saving rate runs head-on into large fiscal deficits. Rising interest rates would affect investments and impede economic growth. And with a debt-to-GDP ratio of near 200 per cent, the higher interest rate would eventually raise the government's interest bill resulting into vicious spiral of rising deficits and debt.
So how much is really too much?
As mentioned in the very beginning of the article, there is no one particular value of debt-to-GDP ratio which can be termed as sustainable. The study of debt conditions in Greece and Japan above show that there are a variety of factors which come into play if one wants to look at the debt-stability of a nation. One of the factors is the investor sentiments. So far as the investors have confidence in the government bonds, the country can keep borrowing money and service its debts. When the financial market believes that the national debt of a country has reached a point at which servicing the debt becomes too big a burden, it will stop lending the government.
Also, nations which are unable to issue bonds in their own currency have a greater likelihood of a debt crisis due to currency mismatch as a decrease in the value of their own currency may then make it prohibitively expensive to pay back their foreign-denominated bonds. On the other hand, Governments which can borrow in their own currency run a lesser risk of a debt crisis as they can print money to monetize their way out. The holding pattern of the government bonds is another factor which is important. If the bonds are largely held by the domestic investors, then a country would have a relatively higher sustainable debt to GDP ratio as compared to countries which have majority of their bonds held by foreign investors. Also, relying on financing through short-term bonds may leave Governments especially vulnerable as this could result in a situation of maturity mismatch between their short-term bond financing and the long-term asset value of their tax base.