Why you should be worried about global debt levels

Financial Armageddon? At least you reacted…

Readers’ reactions to my piece in this month’s MI magazine on the theme of Financial Armageddon were, as usual, intelligent and interesting. In case you missed it, I was arguing that risks in the global financial system have been rising inexorably to a point where another systemic financial crisis in the near to medium term is probably more likely than not. I argued that what was especially worrying was the continued build-up of debt by governments and the private sector across the globe.

Some readers thought that I was scaremongering – an accusation that I would counter by saying that it’s my job to evaluate the balance of risks, as best I can. (I said: it’s not inevitable, but…)

I was intrigued when a reader by the name of Steve wrote in arguing that, actually, debt is not a problem at all.

Other readers argued that Financial Armageddon will be a mere side-show to Climate Armageddon. That is certainly not stupid – I think anthropomorphic climate change is happening; yet I’m not a climate pessimist. (Al Gore promised us the Arctic ice cap would be gone by 2013. It’s still very much there.) And I’ll look at the prospective impact of climate change on the investment outlook in more detail soon. For now, however, it’s worth noting that my time horizon for Financial Armageddon is three to five years out; whereas the time horizon for Climate Armageddon is probably 20 to 60 years out.

But I was intrigued when a reader by the name of Steve wrote in arguing that, actually, debt is not a problem at all…

Steve argues that one man’s liability (debt) is always another man’s asset (loan or bond). Countries lend one another money all the time, so a lot of outstanding government debt could be cancelled out at the stroke of a pen. At the end of the day, debt is just something created by financial institutions, which can therefore be cancelled by financial institutions. His point is a clever one which got me thinking.

Corporate versus Government debt

In order to unpick this we have to distinguish between corporate and government debt. They function according to somewhat different laws, even if they have – in excess – similar consequences.

And any discussion of debt takes us into the Alice Through the Looking Glass realm of monetary economics. If you lend me a fiver from your wallet, that’s a transfer of assets. (Of course I’ll pay you back.) But if I borrow £5,000 from a bank, that money is conjured into existence out of nothing. So borrowing, or credit creation, as economists have it, affects the functioning of the economy as a whole.

Companies (corporations in American-ese) borrow money from banks for three reasons. Loans are either intended to finance working capital (paying wages, purchasing inventory etc.); to purchase an asset (a building or new plant); or to refinance existing permanent debt.

Companies can borrow subject to banks’ estimations of how much debt they can reasonably bear. Remember that borrowers must repay the debt over time (normally in instalments) and pay interest on the outstanding balance, normally on a floating rate basis (cost of funds – LIBOR – plus a margin). Capital repayments and interest payments are paid out of cash flow (not profit). The more mature the company, normally, the more stable (i.e. less volatile) its cash flow.

Younger, faster-growing companies are financed overwhelmingly by equity. Returns to shareholders arise through capital gains as at this point they as will not receive dividends. But, as companies mature they tend to take on more debt as a total proportion of their balance sheet. In banking parlance, they become more highly leveraged. I tried to explain how investors need to understand the company life cycle (which closely follows the product life cycle) in a piece that I wrote in these pages last year. Essentially, when a company ceases to grow (because the market for its products is static) we can expect it to be highly leveraged, perhaps 50 percent debt and 50 percent equity. At that point all returns to shareholders will tend to come from dividends, with minimal capital gains.


Large mature companies have high levels of debt which they never expect to extinguish – as the debt matures, so it is refinanced with new loans. Hence they call this debt permanent finance. You can expect a mature manufacturing company to have a relatively high level of permanent finance.

Banks have a pretty shrewd idea of how much debt a company can bear by reference to a borrower’s leverage ratios and interest coverage ratios (how many times interest cost is covered by cash flow). But even the most solid borrowers can run into trouble in difficult market conditions, or in times of recession, when default rates spike. A level of default in line with market expectations is not a disaster for banks so long as their pricing policy covers that expected level of default. So, for example, if the default rate is one percent per annum (one in every one hundred dollars of outstanding loans is not repaid) then the average margin over the bank’s cost of funds should be at least one percent.

Now when and if a corporate borrower defaults (through bankruptcy) on all its loans, the corresponding loan assets on the lenders’ balance sheets are written off and the banks’ capital is reduced accordingly. Therefore, corporate defaults reduce the available capital in the banking system; and hence the ability of banks to lend money to new borrowers. You can think of it as the money disappearing into a giant black hole – making us all poorer.

A growing economy depends on a dynamic banking system. Economies with excessive levels of corporate debt will endure higher levels of default and will not grow as fast as economies with modest levels of debt. Of course, so long as companies remain well capitalised, maintaining reasonable ratios of debt-to-equity on their balance sheets, and so long as banks price loans correctly, a “normal” default rate should not do too much damage to the system as a whole.

There is some evidence that corporate default rates have been rising over the long term. Default rates fluctuate over the business cycle and have been heading up recently. Moody’s reported in March this year that the corporate default rate on high-yield instruments (junk bonds) was likely to rise to 4.2% in January 2017 – which is actually in line with Moody’s 40-year average[i]. That could be a sign of a coming recession.

Government debt – the borrower has no balance sheet

Unlike corporations, governments do not have balance sheets and therefore we cannot determine how leveraged they are. This seems quite strange because obviously governments do own things – the UK government owns cash at the Bank of England, land, aircraft carriers, submarines, hospitals and even shares in Royal Bank of Scotland (LON:RBS). But, although economists have mooted how they might draw up state balance sheets, there is still no agreed methodology.

Even if governments own assets, that is not necessarily a good thing. Privatisation was about selling off state assets (the family silver as Harold Macmillan put it) for the good of the economy as a whole. Pro-market thinkers believe that government should stick to its knitting and leave the business of wealth creation to the private sector.

As it happens, the people who buy government bonds (mostly institutional investors such as pension funds) don’t evaluate a government’s ability to repay that bond by reference to its balance sheet. Rather, they look at two key metrics.

The first is the ratio of the total outstanding stock of national debt to total GDP. And the second is the ratio of the current year budget surplus or deficit (current year revenues from taxes minus current year government expenditure) as a percentage of GDP. On both of these metrics most governments are currently declining in credit quality.

If, as in the UK, the budget deficit is running at two percent of GDP, we can expect, all things being equal, that the debt-to-GDP ratio will also rise by two percent this year (less the amount by which the economy grows). The waters are muddied somewhat by the fact that the government is constantly redeeming expiring debt and refinancing it with new debt issues – just as mature corporations carry permanent finance.

And the fact is that government debt, when issued in its own currency, is effectively risk-free. If governments run short of money they can raise taxes (though that may damage the economy). Furthermore, governments – and governments alone – can print money in order to repay their creditors. (Of course such action risks inflation, which, in turn, may cause the currency to weaken.)


Government defaults on foreign currency debt are historically common. It does sometimes happen that governments default on domestic debt – like Russia in 1998 – but that is rare. Since the beginning of the industrial revolution major sovereign defaults have been disarmingly regular. In a fascinating study entitled This Time is Different, Harvard economists Carmen M Reinhart and Kenneth S Rogoff record an extraordinary litany of sovereign defaults. Before WWI, Spain, Portugal, Turkey and many Latin-American countries defaulted numerous times. Russia defaulted in 1917, 1992, and then again in 1998.  And yet, until Mr Putin annexed Crimea in 2014, Western banks were queuing up to lend to him.

The USA has never defaulted since the Founding Fathers convened. But the State of Pennsylvania has defaulted, as well as numerous counties, most famously Orange County, California in the 1990s. Argentina, a serial defaulter, went bust in 2002 after ten years of the One-to-One-Peso-Dollar Parity policy (another ill-conceived currency union). The default affected US$100 billion of debt. There are still hedge funds pressing lawsuits against Argentina on behalf of aggrieved bondholders.

And there is no universal rule as to what level of national debt triggers default as there are too many variables. Most defaults, according to Reinhart and Rogoff, occur with a debt to GDP ratio of below 60 percent. (Greece’s is currently nearer 200 percent.) Sovereign default can occur even if a country has relatively low levels of debt but has a liquidity crisis and runs out of cash.

Yet the Harvard professors concluded that financial markets always recover from sovereign defaults, after an initial crisis, despite the systemic risk associated with a thrombosis in the government bond market. A systemic banking crisis, such as the one that was narrowly averted in 2008, is much more dangerous than an idiosyncratic government default.

But the fact is that when governments default, just as when corporates default, the corresponding assets held by debt holders are wiped out – and wealth is destroyed.

As for government-to-government lending, this accounts for a very small part of most countries’ overall borrowing, unless we include IMF loans to developing countries. True, for example, the UK government lent the Republic of Ireland £8 billion during the Irish banking crisis of 2010 – largely to facilitate continued trade between the two countries. But such bilateral loan assets are dwarfed by the massive volume of government debt outstanding – currently about £1.6 trillion for the UK, or about 83 percent of GDP.

Rates of return are falling in the Age of Debt

At Master Investor we celebrate the creative destruction of capitalism. Bust businesses and governments often go on to do great things. Even bankrupt individuals can learn from their mistakes and prosper. But excess debt in the system is still a major risk factor.

There is another problem lurking beneath. 200 years ago, at the beginning of the industrial revolution, rates of return were phenomenal. Investors could put a few Pounds or bucks into a textile mill or a railroad and reap massive returns. Where are the returns today? Technology and biotech? Perhaps – if you can find the right opportunities.

I am now convinced that we are nearing the end of this Age of Debt.

The global economy right now is beginning to resemble the mature corporations that I described, financed largely by permanent debt (not equity) and with stable, but not increasing returns. Zero or negative interest rates obtaining today are not so much a function of stagnant demand (as the central bankers claim) as of pitiful returns on equity. So long as returns on equity are slight and the cost of debt is low, rational actors will favour additional debt. And this build-up of debt further depresses returns.

In my dialogue between Sherlock Holmes and Dr Watson during the summer I tried to explain how increased government borrowing crowds out private investment, and thus depresses growth (and ROE) further – in a vicious circle. I am now convinced that we are nearing the end of this Age of Debt. What lies beyond it is something I’ll explore soon.

Over to you, Steve.

[i] See: http://www.marketwatch.com/story/corporate-defaults-expected-to-rise-30-in-2016-says-moodys-2016-03-01