SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds

Subscribe via email

Grab our RSS Feed

Bank for International Settlement report does not bode well for world economy

I normally don’t write blog posts on the weekends but I feel I should get this post out sooner rather than later because some of the information may be time critical.
Warning: this is long blog post with few pictures.

A friend of mine recently asked me why I was still bearish about the stock market. Like many other retail investors, she has jumped back into the stock market. My answer was basically two things:

1. the sovereign debt problem
2. the demographic problem

When the banking crisis hit us in 2008, many people said it was a “black swan” event i.e. something rare that could not be predicted. However, we cannot say that about the above two problems. We know roughly how much debt countries have and we know how old people are in each country. We also know how much the current costs are to service debt and to maintain current age benefits so we can easily extrapolate this to see what is in store in the future. That is exactly what the Bank for International Settlement (BIS) has done and their findings are quite scary. In case you have not heard of the BIS, they are often called the “central banks’ central bank” so they have a truly global perspective. This 26 page report “The future of public debt: prospects and implications” was released on their website last week. The abstract of the report is:

“Since the start of the financial crisis, industrial country public debt levels have increased dramatically. And they are set to continue rising for the foreseeable future. A number of countries face the prospect of large and rising future costs related to the aging of their populations. In this paper, we examine what current fiscal policy and expected future age-related spending imply for the path of debt/GDP ratios over the next several decades. Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability.”

Sovereign debt problem

We have all heard about the large government debt problem but do we need to worry about it today? According to the OECD, the total industrialised country public sector debt is now expected to exceed 100% of GDP in 2011 – something that has never happened before in peacetime. Well, 2011 is next year, not some time in the far distant future.

Should we be concerned about high and sharply rising public debts? Several advanced economies have experienced higher levels of public debt than we see today. In the aftermath of World War II, for example, government debts in excess of 100% of GDP were common, and none of these led to default. In more recent times, Japan has been living with a public debt ratio of over 150% without any adverse effect on its cost. So it is possible that investors will continue to put strong faith in industrial countries’ ability to repay, and that worries about excessive public debts are exaggerated. Indeed, with only a few exceptions, during the crisis, nominal government bond yields have fallen and remained low. So far, at least, investors have continued to view government bonds as relatively safe.

However, the report goes on to say that bond traders are notoriously short-sighted: their time horizons are days or weeks, not years or decades. The authors take a less benign view of current developments, arguing that the aftermath of the 2008 banking crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point. Is this boiling point about to be reached in Greece? Greek bond yields have been rising throughout all of last week as bond traders became increasing impatient with the leaders of the Eurozone countries and the IMF to come up with a credible bailout plan for Greece. The risk of default is increasing. Fitch, one of the three biggest credit rating firms, lowered its assessment of Greece’s creditworthiness on Friday (April 9) by two notches to the lowest investment grade and said the outlook remains negative. They also lowered the ratings on the National Bank of Greece, the nation’s largest bank, along with four other major banks by one notch to BBB-, the lowest investment-grade rating, and Fitch said the outlook remains negative. Any rating below BBB- is considered “junk” grade and most investment institutions (e.g. pension funds) will generally not buy non-investment grade assets as they are deemed too risky.

Demographic problem

More worryingly, the current expansionary fiscal policy (for bailouts, stimulus spending etc) has coincided with rising, and largely unfunded, age-related spending (pension and health care costs). Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply. Interestingly, this rise is concentrated in countries such as Japan, Spain, Italy and Greece, which are already laden with relatively high debts (see graph below, left-hand panel). Added to the effects of population aging is the problem posed by rising per capita health care costs. The right-hand panel of the graph below shows the estimated incremental age-related outlays between 2011 and 2050. As you can see, these numbers suggest that the distribution of age-related spending is uneven across countries, with the burden highest in Greece!

All the above reinforces what former IMF Chief Economist Simon Johnson said in his April 6 blog post about how he thinks the Greece problem is likely to play out. Based on his calculations, the government’s current macroeconomic program (including the severe austerity programs) is not nearly enough to calm markets, or put Greece’s debt on a sustainable path. By 2012 he estimates Greece’s debt/GDP ratio will rise from 114% of GDP to over 150%. When Simon Johnson first said in January 2010 that the IMF would be involved in bailing Greece out, it seemed far fetched as everyone expected members of the Eurozone to come to Greece’s rescue. Well, the IMF involvement has come to pass so I believe what he is saying now will also come to pass in months to come. From the lessons learned from Argentina’s debt crisis, he thinks the only real solution for Greece is to default on their debt. However, there are also powerful personal interests that will guide these decisions, including the current head of the IMF who is primarily focused on becoming the next President of France. I will leave any interested readers to read about this in Simon’s blog post. It is a fascinating read and I suggest that it will be well worth your time to do so.

What happens if Greece does default? Many banks will suffer big losses, especially in Europe. Once again, we could have another credit crisis as banks worry about lending to each other or taking letters of credit, which would be a disaster for world trade and the recovery we are now in. The next credit crisis will be worse as we will not have the tools available to stem the tide that we did the last time. Interest rates are already near zero so they cannot be lowered further. Governments are already in so much debt they cannot afford to provide more bank bailouts.

Whether Greece does default or not, the BIS assessment does not bode well for the world economy. Unless drastic measures are taken to check the rapid growth of current and future liabilities of government, things will only get worse. I don’t see much political will to do what it takes so I don’t think this crisis will end well. Every government wants to look good today and just “kick the can down the road” and let future governments deal with the problems. In Australia, the current Labor government also knows we have an aging population problem and has done little to address this. The previous Liberal government did take action by changing the superannuation rules to encourage people to put more into their retirement fund while they are still working to enable them to fund their own retirement instead of relying on government pensions. The current Labor governments changes to the superannuation contribution rules by reducing the maximum allowable contribution by 50%, allows the government to obtain access to more tax dollars today, and is a case in point of shortsightedness of the problems of an aging population . As tail end baby boomers, we do not hold much hope that there will be any money left to provide us with an adequate pension when we retire. Despite all the headwinds, we are determined to find ways to increase our super and will share any good ideas with you through this blog.

Leave a Reply