Debt in the Western world – divergence from the convergence criteria

Debt in the Western world – divergence from the convergence criteria
The government debt/GDP heat map shows most of the West is being dragged down by huge public debt.
By Henry Kirby in London April 29, 2016

Debt levels among Western nations are dangerously high and acting as a huge drag on global growth, according to the International Monetary Funds’s latest World Economic Outlook (WEO) report. The “new mediocre” that IMF chief Christine Lagarde warned of in 2014 has become a reality.

The “high debt, low inflation and low investment” that Lagarde described in an April speech was followed by a warning in the latest WEO released on April 12 of a serious risk of “a world economy that reaches stalling speed and falls into widespread secular stagnation”.

The world used to be divided into “haves and have nots”, with the developed markets (DM) having all the material luxuries and the emerging markets (EM) having very little. After a bit more than two decades of transition the world has changed in a fundamental way. It is still divided into the haves and have nots, but the difference now is that the EM are buying most of the little luxuries that make life worth living, while what the DM are acquiring most of is debt.

A recurring theme in the IMF’s report is the significant “debt overhang” that advanced economies, and to a lesser extent some emerging market economies, have saddled themselves with. The result has been an explosion in the size of public debt burdens in Western countries, twinned with increasing budget deficits that prevent them from taking any meaningful action to kick-start the global economy and prevent the stagnation that the WEO is warning of.

That’s a big problem. The DM used to dominate global politics and growth by dint of their economic prowess, but as Dr Jerome Booth pointed out in a recent comment on bne IntelliNews the world is now upside down and it is increasingly the EM that are in the driving seat.

“Emerging markets had largely driven the recovery,” Lagarde explained in her April speech, “and the expectation was that the advanced economies would pick up the growth baton. That has not happened.”

That leaves EM on their own, which may not be such a bad thing for regions that are currently enjoying low inflation, low debt and, importantly, low costs of borrowing.

While volatile currencies in energy-exporting Commonwealth of Independent States (CIS) economies have led to higher central bank policy rates and therefore a greater cost of corporate borrowing, net commodity-importing Central and Eastern Europe (CEE) is enjoying a climate of low-cost financing with vast scope for an increase in volumes of debt issued, as the first bneChart shows.

With ample space for an increase in low-cost borrowing, CEE economies could comfortably borrow in order to meet the requisite levels of investment for growth beyond the “mediocre” levels that Lagarde has described, and in doing so preclude an unnecessary increase in public debt.

Debt and Eurozone

As the second bneChart shows, levels of public debt among advanced economies have skyrocketed since the 2008 financial crisis. Of the 23 European and Central Asian countries that in 2015 had public debt above the EU’s euro convergence criteria (also known as the Maastricht criteria) threshold of 60% of GDP – considered to be the upper “safe” limit for a country’s debt – 15 of them were developed markets. Of the eight above the EU threshold for unsustainable debt of 90% of GDP in 2015, not one was an emerging economy.

These thresholds are significant. The study that the EU based them on found that government debt above 60% adversely affects EM growth to the tune of roughly 2 percentage points (pp), and debt over 90% does so by roughly 4pp. For DM, growth is unaffected at 60-90% debt, but falls by an average of 3pp above 90%.

Much criticism has been heaped on Russia over its recession, but with debt at only 21.4% of GDP, its problems should be fixable if only the Kremlin were to implement effective reforms. Not so for Greece, Italy, Portugal, Belgium, Spain, France, Cyprus and Ireland – all of which have debt over 90% of GDP, which hangs like a millstone around their economic necks. The only big European country that is not suffering from over-indebtedness is Germany at 66.8%.

Indeed, if the EU’s five founding countries had to to re-sign the Maastricht Treaty that was agreed by member states in 1991 as part of the preparations for the introduction of the euro, then only tiny Luxembourg would meet the 60% debt/GDP ceiling. Indeed, only 11 of the EU's 28 member states actually currently meet the Maastricht criterion on debt – all bar three of them CEE states. 

The West has been wanton in its borrowing, but the east refuses to borrow at any price, because of the growth burden it puts on economies. Borrowing too much is also dangerous; as Dr Booth points out in his piece, “corporate bond defaults are now higher in the West than in emerging markets.” A note from Russian investment bank VTB Capital touches upon the same point, explaining that nervy EM corporates are holding back on investment because they “do not want to borrow and add to their debt burdens, regardless of how low interest rates and borrowing costs become”.

Limits to borrowing are even enshrined in the constitution in Poland, where the government’s ability to borrow is capped by law at 55% of GDP – a measure many countries in the West would be well advised to adopt (Poland’s debt is currently 53.5% of GDP).

The reticence among EM entities to issue debt, despite favourable borrowing conditions, could lie in a fear of external forces that are beyond their control – the most powerful of which would be unpredictable currency pressures.

One of the worries about the creditworthiness of developing economies is the historical instance of sovereign default among EM nations. A 2003 IMF report noted that the size of the debt burden among defaulting EM economies over the 30 years preceding the report’s publication tended to be low. In 55% of recorded EM defaults, public debt was below the EU benchmark of 60% of GDP. In 35% of cases, it was even below 40% of GDP.

Since then, however, the currency exposure of EM has decreased significantly. According to a recent report by ratings agency Moody’s Investors Service, local currency sovereign EM debt grew on average by 14.5% each year between 2000 and 2014, while the average public debt burden increased by only 0.4pp, suggesting a realignment of EM debt towards domestic currency issuance and away from riskier hard currency issuance.