The Developed Economy Debt Hangover is set to linger
If there is one thing the public sector debt crisis in Greece has clearly illustrated then it is how rapidly fiscal dynamics can become unsustainable. Governments that have presided over the rapid deterioration of budget balances, against the backdrop of debt levels that were high to begin with, need to take note.
As private sector deleveraging gathered momentum in developed economies last year and domestic demand declined sharply in the wake of the credit crunch, governments had to step into the breach to prop up spending. Failure to respond would, conceivably, have plunged economies into depression. The intervention, through an array of tax incentives and expenditure programmes, in addition to concerted monetary policy intervention, did the job. Inflation expectations stabilized, asset prices recovered and depression was averted.
However, the problem is that fiscal intervention has caused a marked deterioration in primary budget balances (revenue less non-interest spending) of a number of countries – most notably in developed economies. In the Euro area, Ireland, Greece, Portugal and Spain stand out. Outside the Euro zone, the fiscal authorities in Japan, the UK and the US have also presided over marked increases in their primary deficits against a backdrop of high debt levels.
The problem is much of the deterioration in budget deficits reflects structural changes, rather than temporary influences due to the downturn in the economic cycle. Not only are structurally bigger deficits difficult to address because unpopular decisions must be taken by elected officials, but they also take a long time to reverse – years!
It is difficult to predict the future path of a country’s debt level. The outcome depends on the pace of real growth, the level of interest rates, the inflation rate, policy decisions and the willingness to sell assets if required. But, projections, including the International Monetary Fund (IMF) which are based on reasonable assumptions for these variables, point to marked further increases in the debt levels of developed economies. Indeed, the IMF expects the gross debt level for the group of developed economies, on aggregate, to increase above 100% of GDP in the years ahead.
Governments facing high and rising debt levels need a strong, extended rebound in economic growth. If the real interest rate is higher than the real growth rate in the economy, a government must run a sufficiently big primary budget surplus just to stabilise or reduce the debt ratio. The problem for governments such as Spain, Portugal and Ireland, however, is that inflation is either low or declining, implying upward pressure on real interest rates against the backdrop of palpably weak real economic activity and government revenue growth. Only a sharp contraction in government expenditure can alleviate the situation.
Hence, the fiscal austerity measures required amongst developed economies to address the deterioration in their fiscal positions are material. For example, the IMF estimates that in order to reduce the gross government debt ratio for advanced economies back to 60% of GDP by 2030, the cyclically adjusted primary balance of these economies will need to improve by 8.7% of GDP, from a deficit of 4.9% of GDP in 2010 to a surplus of 3.8% of GDP in 2020. Of course, as the IMF suggests, the advanced economies could target a less challenging debt level, but this would imply relatively limited room to maneuver in response to any adverse developments that may arise over the next two decades.
If governments address their fiscal problems effectively bond market participants are likely to push interest rates higher. Either way we can anticipate an adverse impact on growth. The US and the UK have already laid out their plans to reduce their fiscal deficits materially. Expect economic growth in developed economies in the years ahead to disappoint relative to their established long-term trends.
Meanwhile, although emerging markets, including South Africa, have not de-coupled from developed economies – implying they are not immune to any material slowdown in real economic activity in developed economies – the relatively well contained response of their bond markets and currencies to events in Greece is telling.
Indeed, at the time of writing, the emerging market bond index spread remains relatively well behaved, suggesting there is no material increase in risk aversion towards emerging markets as yet. Looking ahead, bouts of volatility may well occur in emerging market asset prices as the global debt issue lingers. But, the relatively healthier fiscal position of emerging economies stands them in good stead. For example, the IMF estimates an adjustment in the primary balance of only 2.7% of GDP is required to reduce the level of debt for these economies to just 40% of GDP by 2020. This is one reason to except emerging market economies to perform relatively better than developed economies in the years ahead.
Information provided by Arthur Kamp, Investment Economist, Sanlam Investment Management