High leverage is a telltale sign of trouble, whether it’s a company or a country, so beware when investing in such countries, says economist.
Q: According to globalresearch.ca, 24 nations worldwide are currently facing a debt crisis. After the Greek financial tragedy, I worry whether I should take into account the indebtedness of a nation when considering buying property overseas. I have been told technically, a country can go on being indebted forever as long it is still showing growth. So, should I worry about my property investments in the US (the largest debtor nation in the world) and Japan?
My second question is if the worst happens and the country defaults on its loan obligations e.g. Greece and Cyprus, what would likely happen to my property investments? Should I bail out at the slightest sign of sovereign insolvency or should I stay on till the thing blows over?
Shan Saeed: Yes, you have to take into consideration when buying real estate in a country whether the debt levels are high and fiscal space is under stress. Sovereign debt risk has become the new headache for IMF/World Bank. The challenge for IMF today is even more severe than it was 40 years ago. Sovereign risk has become an everyday nightmare for IMF with countries confronting mountains of debt including internal and external debt, swollen fiscal deficits, currency depreciation, abysmally low GDP growth and above all, poor risk management by financial institutions.
As we navigate through turbulent times, governments in advanced economies and emerging markets are getting wary of countries with huge debt, mismanaged economies and poor ideology of some governments in the global economy.
How can you tell which countries are really in trouble? You might look to the country’s ratio of government debt to gross domestic product. A government’s public debt, poor fiscal management, depreciating currency, higher inflation rate, lower GDP growth and weak purchasing power are all indicators of country heading towards default.
From 2015 to 2018, I predict there would be many countries in trouble due to debt defaults and corporate bankruptcies. Advanced economies like the United States, UK and Japan, which are increasing government spending to shore up slack economies and mounting budget deficits are raising concern about governments’ ability to shoulder their debts, especially once interest rates start to rise again.
The important indicators of a country heading towards default include increased public debt and budget deficit; higher inflation; depreciating currencies; lower productivity, GDP growth rate and Foreign Direct Investment; low credit growth and money supply in the economy; banking system under stress, and above all jittery investors who are bearish about the country. Once fear goes into the economy, it is like a depreciating asset hurting the country.
According to the June 3, 2015 issue of The Economist magazine, public debt in rich countries exploded between 2007 and 2012, rising from an average of 53% of GDP to nearly 80%. Some people think this is a problem and say that governments need to do their best to cut it. But that view has been challenged in a new paper from the International Monetary Fund, which suggests that “paying down the debt” (or in the words of George Osborne, Britain’s Chancellor of the Exchequer, “fixing the roof while the sun is shining”) is not the most sensible approach.
The IMF’s economists reckon that if a government could choose between having high or low debt today, then all else being equal, they would (and should) choose the latter. After all, when debt is high, governments have to impose unpleasant taxes to fund spending on debt-interest payments. These taxes are a drag on the economy leading to sub-par growth.
But when a government is faced with a high debt load, is it better to impose austerity and pay it down, or take advantage of low interest rates to invest? The answer depends on the amount of “fiscal space” a government enjoys.
For those countries with no headroom (in the red or amber zone on the chart), the IMF’s paper is not much use – they need to take action to reduce their borrowing levels. But for countries well into the green zone (of which America is a star performer and Britain is a somewhat marginal case), the IMF’s analysis has a clear message – don’t worry about your debt.
For countries safely in the green zone, the authors present an example of a country reducing its debt from 120% to 100% of GDP. They calculate that the expected costs of the higher taxation (for instance, from the disincentives to work created by increased tax rates) are likely to outweigh the expected benefits (from the lower risk of a default in the event of a crisis) by a factor of ten.
A bubbly proposition
New research suggests it is debt, not frothy asset prices, that should worry regulators most. Not all bubbles, it would appear, are equally bad. The crucial variable that separates relatively harmless frenzies from disastrous ones is debt. In many cases, though certainly not all, stock market manias fall into the less worrying category.
Writing for the National Bureau of Economic Research, Oscar Jorda, Moritz Schularick and Alan Taylor examine bubbles in housing and equity market over the past 140 years. The most dangerous, they conclude, are housing bubbles fuelled by credit booms. The least troublesome are equity bubbles that do not rely on debt. Five years after the bursting of a debt-laden housing bubble, the authors find, GDP per person is nearly 8% lower than after a “normal” recession (i.e., one that is not accompanied by a financial crisis). The paper does not explain why housing bubbles are more costly, but a fair inference is that, whereas equity investments tend to be concentrated among the rich, plenty of people lower down the income ladder have wealth tied up in housing.
That makes sense. Stock-market routs typically harm the economy via the “wealth effect”. When people see that their assets are worth substantially less than before, they spend less, leading to weaker demand and, ultimately, weaker investment. Debt can make this worse. Those who have borrowed to invest may be forced to sell assets to avoid defaulting, further depressing prices and wealth. Banks that have lent to investors or accepted shares as collateral will also suffer losses. That forces them to rein in their lending, harming the economy even more.
After analysing and examining 400 years of asset-price bubbles, be it tulips, land, housing, derivatives or shares, I have found that the consequences of a bursting bubble depend less on the type of asset than on how it is financed. High leverage is the telltale sign of trouble. In a nutshell, fear and confidence have become the 2 most significant non-economic variables in the macro–equation during the present times. If you have property investment in the regions where Debt to GDP is higher or the country which has defaulted on her payment obligations, then get ready to have a downward revision of your asset classes in all categories.
Shan Saeed is Chief Economist and Investment Strategist at IQI Group Holdings, a property and investment company operating and advising clients in Kuala Lumpur, Singapore, Hong Kong, London, Melbourne and Dubai.