The web of debt - out to snare the unwary

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In 2007 and 2008 most people wondered what the “credit crunch” was, and what it meant to them. We don’t need to get into a debate again about whether there was in fact a credit crunch, but there was certainly a huge web of debt, at the centre of which was mortgage debt, and from there it became increasingly complex and murky, and, in some instances illegal. From the Summer of 2007 it began to unravel.

the lesson of the 1930s

Some of us thought that the problem could be contained, and that while economic growth might be lower for a number of years, we didn’t need to panic. Then in September 2008 the giant US bank Lehman Brothers was allowed to fail, and the global banking system was on the verge of collapse. The lesson of the early 1930s was that the closure of “Main Street” banks touched the day to day lives of ordinary people, hit confidence, and was a major factor in an unpleasant recession turning into the Great Depression.

The Bank of England has subsequently told us that in the Autumn of 2008 they were within seconds of closing High Street cash machines and banks.

Thankfully the lesson of the early 1930s was sufficiently understood, so from September 2008 central banks and governments around the world pumped vast sums into the global banking system and economy, and the world’s economy was pulled back from the brink (though still suffered the fastest downturn since the 1930s).

This action in 2008 did prevent a much worse crisis at that time. But it has given birth to a new problem, which needs tackling urgently. The net result of these global rescue packages is that most developed economies have transferred troublesome debt from the private sector (banks and consumers) to the public sector, the Government. History tells us that the volume of government debt now accumulated is a serious problem.

This government debt is in the form of bonds, mostly held by banks and other financial institutions. So if a country cannot meet its obligations the impact is profound and stretches way beyond its own borders. Banks and governments in these five under-pressure economies (Greece, Italy, Ireland, Spain & Portugal) owe each other vast sums - and even more is owed to the UK, Germany and France.

It has been said that the Greek rescue package, with Germany being the main contributor, wasn’t so much to rescue Greece, rather it was German taxpayers bailing out the French banking system, which couldn’t cope with the losses if Greece defaulted.

the system works - usually!

These government bonds, such as Gilts in the UK or Treasuries in the US, have terms of a number of years, and they pay interest to investors until they mature. Ideally, when they mature the government will repay that debt; but if they don’t have enough money at that point, they rollover the old bond into a new bond, and typically investors are happy to buy the new bond.

If the government is spending more each year than it receives in tax revenue (the fiscal deficit you have heard so much about) the accumulated government debt will increase; this is because new bonds are issued to raise money to cover this deficit. It might also grow due to one-off problems such as funding a war or pumping money into the economy to help it pull out of a slump.

Most of the time this works. This is because unlike you and I (who cannot magic up extra income) governments can put up taxes so they have enough income both to repay the interest on the accumulating debt and run the country. 

But at times it becomes unsustainable. That is where most of the developed world is right now, an unfolding sovereign debt crisis.

Recent research (Reinhart and Rogoff) analysed financial crises across 66 countries and five continents over 800 years. What was remarkable was the continual repetition of the features that caused these crises, both across the centuries and nations, small and large. In essence political negligence over years creates the conditions that allow banking crises (e.g. 2008), which then lead to a sovereign debt crisis (2010 onwards), and then currency crises.

History highlights that a country is in trouble once accumulated sovereign debt is 90% or more of GDP (gross domestic product, in essence the size of the economy). The table below shows how many countries already breach this threshold, or are on the verge of doing so in the year or two ahead.

 Debt around the world

For example, the UK’s accumulated debt is now 81.7% of GDP, therefore with an annual deficit of 11.4%, next year the total debt exceeds 90%.

What history doesn’t tell us is how quickly you get to crunch time. For example, Japan’s debt is more than 200% of GDP. So far they have got away with this because this debt was overwhelmingly purchased by domestic investors (this will change soon, and then they will be in deep trouble but that’s a story for another day).

In contrast, if you rely heavily on foreign investors to buy your governments bonds, they will be much more discerning. Once accumulated debt reaches a certain level, and you come to rollover existing debt, foreign investors will demand a higher interest rate to compensate them for the greater risk that the government might not be able to repay the debt. This can become self fulfilling - as happened with Greece in May, the interest rates demanded became so high that the country could not afford to rollover existing to new debt, nor can it afford to repay the bond that is maturing. The EU and the IMF have stepped in to help Greece, but they have only bought time, probably to enable an orderly default. But orderly or not, if Greece can pay its bond holders only 30% of the debt outstanding, those bond holders are going to take a big hit - and those bond holders are largely European banks. Can they afford to take the hit from Greece? Perhaps. But what if it was Spain, Portugal, Italy defaulting?

Greece probably has no choice but to default eventually, which is a final resort. Other countries currently might be able to sidestep default, it will only be by virtue of VERY painful action being taken - there are no easy choices, as we are beginning to understand in the UK.

the UK is not Greece

Although the annual deficit of the UK is worse than that of Greece, the position of the UK is far less acute. Unlike Greece the UK can allow its currency to weaken, which can boost exports, economic growth and the Government’s tax revenue. In addition, the average duration of the UKs outstanding debt is 14 years. This means that the UK doesn’t have to regularly return to the market to rollover existing debt as it matures. Last but not least, the UK does not rely on foreign buyers of its bonds to the same extent as others.

What about the US? The focus has been on Europe so far, and perhaps that is just as well. Greece got into trouble in May because it was due to rollover a few tens of billions of existing debt, and the interest rate demanded by investors went through the roof because the ability of Greece to ever repay the debt in full was seriously in doubt.

But that was small fry - in the next three years the US will need to convince investors to buy $7 TRILLION of their Treasury bonds (which is both rolling over of accumulated debt and new bonds to cover their year to year shortfall in revenue).

We have no idea how the market might react. They might get away with it. After all US citizens are relatively under-taxed, and their economy has considerable dynamism. But voters may begin to show their unease in the November elections with a surge of support for the “small government” Tea Party and the like.

Returning to the UK, the current Government is beginning the period of painful adjustment. Economic growth will be under pressure, unemployment will edge higher still. But the foundation is being laid for a much brighter future, providing that the Government does what it says. In contrast some other countries are already beyond repair (Greece will eventually default) and others have not really begun to address the problems yet (the US and Japan).

still money to be made

It isn’t all negative. As we look at here, you can make money in this environment, and we set out five elements to doing so.

Ideally investors will probably want access to the widest range of asset classes, including the likes of ETFs (exchange traded funds), of which some of you will already be aware. This is now possible through our Wealth Management Platform – if you haven’t heard from us about this yet, do get in touch and see if this might be suitable for you.

(Taken from TopFunds Guide July 2010)

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