The countries that will emerge from this debt crisis soonest and healthiest will be the ones that had less of a build-up in debt before the crisis or that can engineer some positive debt dynamics through a combination of financial repression and money illusion.
IMF and OECD negative outloooks
Current IMF and other forecasts suggest that it will be 2015/2016 before developed countries start to achieve balanced primary budgets, and that is on the assumption of unchanged policies. For some countries it could take longer and only then can we realistically think about debt levels peaking. In the meantime, sovereign solvency concerns will remain a key feature of the financial markets, and the current calm is unlikely to last much into 2013.
There are lots of variables that determine the debt-to-GDP ratio of a country and how it evolves over time. However, the most important are economic growth, borrowing costs and the ability of the government to control its primary budget balance. The closer a country gets to a debt-to-GDP ratio of 100%, the more difficult it actually is to control the debt ratio, especially when growth is weak and primary budget deficits are difficult to bring down.
This is the situation the UK finds itself in today. According to the last IMF World Economic Outlook, the debt-to-GDP ratio is estimated at 88.4% at the end of 2012, rising to a peak of 92.8% by end-2014.
The OECD is more pessimistic, estimating a debt ratio of 104% at the end of this year. Following the budget last spring, the Office for Budget Responsibility forecast that the UK’s net debt-to-GDP ratio would peak at 70.3% in the 2013-14 fiscal year.
However, growth is weak and we are expecting the economy to only expand by around 1% next year. The risk is that these debt/ratio forecasts prove to be too optimistic and the peak in the UK’s level of debt is pushed out beyond 2014.
But it is hard to reduce rates, boost growth and cut borrowing all at the same time. Imagine a country with a debt-to-GDP ratio of 100% and an average borrowing cost of 3%. Before we have even considered taxes and spending, there will be an interest cost of 3% of GDP.
Revenue/cost gap
If the economy can grow at a pace of 3% in nominal terms and if the government can achieve a balance between spending and revenue, then the debt ratio will remain constant. However, imagine that nominal GDP growth is just 1% and the government runs an underlying deficit of 2% of GDP. Under this scenario the debt ratio will grow from 100% to about 104% of GDP.
Now think about a peripheral European country with nominal GDP growth of zero and average borrowing costs close to 5% and an underlying budget deficit of 5% of GDP. If the starting point for debt was 100% then within a year it would be close to 110%. If growth does not increase in year two or the budget deficit doesn’t come down, then the debt to GDP ratio rises very quickly.
If current revenues are insufficient to meet additional costs then borrowing will rise again. While the UK does not have the worst demographics, the UN estimates that in 2020 there will be 30 people of pensionable age for every 100 of working age – so the income-generating asset for the UK economy (the tax-paying, working-age population) will be burdened even more through having to service the debt being issued today and to finance the liabilities that are being pushed into the future.
