Debt has caused more chaos in world financial markets than any other financial instrument, yet entire countries get lured into taking on too much of it.
The Global Financial Crisis wasn’t kind to Greece. The Athens Stock Exchange Index declined 89% in the aftermath of the crisis. Asset managers with exposure to Greece in 2007 got their heads handed to them.
The GFC wasn’t exactly kind to U.S. markets either, but U.S. markets recovered and even thrived in the years after the crisis. The Athens Stock Exchange Index is still down 75% from its 2007 peak a full fifteen years after the crisis.
The GFC ignited a series of events in Greece that the country has yet to recover from. GDP declined due to the crisis, which caused debt as a percentage of GDP to mushroom to over 150%. That caused lenders to question Greece’s ability to service its debt, which caused them to reduce their exposure to Greece. Lenders reducing exposure meant a shortage of lenders, which drove rates on 10-year Greek bonds from 5% to 30%. That of course made Greece’s financial situation even worse.
Greece eventually needed a bailout, which it received first in 2010, then again in 2012. The bailout was contingent upon so-called austerity (that is, forced spending reductions for the government) and tax increases, which led to riots and protests. Classic financial crisis.
While the GFC was the trigger that set events in motion, it was not the root cause. The root case was too much debt. Greece headed into the GFC with federal debt equal to 110% of its GDP. U.S. federal debt at the time was more like 35% of GDP. Greece’s debt-to-GDP ratio was three times that of the U.S..
If GDP is a rough proxy for a country’s ability to service its debt, Greece’s creditworthiness was far inferior to that of the U.S. even before the GFC. Then, the GFC exposed Greece’s vulnerability and set the crisis in motion.
We believe Greece’s fate was largely sealed as early as 2005, a full three years before the GFC. At that point, Greece’s financial crisis was all but inevitable. The exact timing and specific trigger were perhaps unknowable, but the crisis was inevitable.
Debt as a percent of GDP will rise for any country with a balanced primary budget and interest expense as a percent of GDP greater than its GDP growth.
Wow. There is lots in that statement. Let’s unpack it.
A primary budget balance is when total expense not including interest equals total revenue. Revenue pays for non-interest expenses in that case, but not interest. Interest expense is funded with incremental new debt. The debt level for countries running a balanced primary budget therefore increases by the amount of the interest on the debt. The numerator in the debt-to-GDP ratio therefore grows by the interest on the debt.
In order to keep the debt-to-GDP ratio from escalating, a country must grow the denominator (that is, GDP) at the same rate as the numerator. If GDP growth is less than interest expense as a percent of GDP, the ratio of debt to GDP goes up. That isn’t an opinion. It’s the way the math works.
An escalating debt-to-GDP ratio means the country’s creditworthiness is deteriorating year after year, which taken to the extreme is unsustainable. Eventually lenders will begin questioning the ability of the country to service its debt, as they did in Greece, and refuse to refinance. That is when things start to unravel.
So, whereas the crisis hits when the lenders refuse to lend, the point of no return occurs long before the crisis and comes when a country’s interest expense as a percent of GDP is greater than the country’s ability to grow its economy. That is when a country puts itself on an unsustainable pathway to crisis. Not if but when.
Interest expense as a percent of GDP exceeding 3% is a bit of a red flag for us. Most countries, with few exceptions, have difficulties growing their economies greater than 3% or 4% year in and year out. An interest burden above 3% of GDP will eventually rob that country of the option of growing out of its debt problem. The numerator in the debt-to-GDP ratio begins growing faster than the denominator. That becomes unsustainable over time. A Greek-style catastrophe becomes inevitable.
In the years leading up to the GFC, Greece was taking on debt to fund social programs, pensions, and salaries for government employees. Interest on that debt started exceeding 4% of GDP starting in 2005. Since Greece’s GDP was growing 8%, the country was initially able to keep its debt-to-GDP ratio from escalating. But 8% growth is not sustainable for most countries. Eventually GDP growth would slow and its debt-to-GDP ratio would begin expanding. That of course happened with the GFC.
We don’t believe investors had to predict the GFC in order to see the hidden risk associated with Greece. The GFC was just the trigger. Greece had already passed the point of no return when its interest expense hit 4.5% of GDP in 2005. Crisis was inevitable. Not if but when.
Remember, hidden risk causes no harm until it is no longer hidden. Capital is permanently lost only when hidden risk becomes broadly obvious. As investors, the time to protect ourselves from a Greek-style financial crisis is after a country passes the point of no return, but before the actual crisis. That is the time to protect a portfolio from permanent capital loss.
At KP7, we routinely scan the investment horizon for countries that might be in the zone of hidden risk, for those countries who run a balanced primary budget (or worse) and whose interest expense as a percent of GDP is higher than that country’s likely long-term GDP growth rate. Those are the countries that are on an unsustainable pathway. Those are the countries that will find it very difficult to grow their way out of their debt problems. Those are the countries whose creditworthiness will continue to erode until their lenders, suddenly aware of the risk they are taking, begin questioning the countries’ ability to service their debts in fully-valued currency.
Several countries around the world are in that zone of hidden risk: past the point of no return but before a trigger has set a crisis in motion. The country we are most concerned about at the moment is the United States, especially given its size and the myriad of touchpoints it has with other economies around the world.
Interest expense on U.S. federal debt will hit 4% of GDP this year and likely 5% next year. That interest burden is not only far in excess of the likely long-term growth rate for U.S. GDP, but is also growing at an alarming rate. The U.S. is on a pathway of ever-increasing debt relative to its GDP. That is unsustainable. The U.S., we believe, is headed for crisis. Not if but when.
