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Debt sustainability

Not so risk-free
Feb 11th 2010
From The Economist print edition

Which countries have the biggest problems?

MARKETS have suddenly woken up to the idea that not all government debt is risk-free. There is a long and not very honourable history of sovereign default, either explicitly or implicitly via inflation and currency depreciation.

So which countries are in the biggest trouble? The ability of a government to honour its debt depends on a number of factors, in particular the size of the debt burden relative to GDP, the interest rate paid on that debt relative to the economy’s growth rate and the size of the government’s primary budget balance—the surplus, or deficit, before interest costs.

If the interest rate paid on public debt is higher than the economy’s growth rate, the stock of government debt will rise as a share of GDP unless governments run a primary budget surplus. The bigger the stock of debt, the bigger that surplus needs to be. This arithmetic suggests that countries with big primary deficits, big debt stocks and a big gap between interest rates and growth are most vulnerable.

This can be a self-fulfilling process. Investors will worry about governments’ ability to service their debt and will push up yields, making debt servicing even harder. The shorter the maturity of the debt, the quicker this problem will arise. And if the debt is denominated in a foreign currency or held largely by foreign creditors, then a debt crisis can be compounded by a currency crisis.

The table shows the main sources of vulnerability for a range of OECD countries. The first column shows each country’s primary deficit or surplus adjusted for the economic cycle. The second column shows the OECD’s forecast for each country’s net debt-to-GDP ratio in 2010. The third column measures the gap between bond yields on debt of average maturity for each country and the OECD’s forecasts for growth in 2010 and 2011. The bigger the negative number, the bigger the problem (although longer-dated debt tends to pay higher yields, so this measure may disadvantage countries which have less refinancing risk). The countries are ranked by adding together their relative league-table positions on these three measures, a rough gauge of the scale of their debt problems.

The fourth column adds another source of risk—the average time to maturity of outstanding government debt. Countries with shorter maturities are more likely to face refinancing problems than those with longer ones. Two big borrowers stand out on this measure: America, for its short debt maturities, and Britain, which can draw some comfort from the lengthy duration of its debt.

Countries that come out badly from the tables may not default, of course. Japan looks worrying on many measures, for example, but has long been able to fund itself by issuing government debt to domestic investors. America’s debt remains the sanctuary of choice when risk aversion rises. Some, like Ireland, have already taken tough decisions to get their finances under control. But as Greece and others are finding out, they will all face severe pressure from the markets to bring their deficits under control. And that may cause a political as well as a fiscal crisis.

Economist article

Labels: economist, finance