Soaring G7 Government Debt and the Interest Rate Paradox

May 28 2010

Ranga Chand’s Notes on the Global Economy & World Financial Markets – May 2010

Soaring G7 Government Debt and the Interest Rate Paradox
 
While the focus of investors is currently on the debt crises that are plaguing Greece, Spain and Portugal, it is important not to forget – lest one gets blindsided – that all the major economies of the G7 also face serious budgetary and debt problems. To date, G7 governments have benefited enormously from the prevailing low interest rates and, despite soaring deficits and debt levels, the cost of servicing the debt has actually been declining. But, as investor angst about the fragile state of the global recovery spreads and deepens, this sweet spot could come to an abrupt end. Jittery credit markets are likely to push up the cost of credit and this will make life much more difficult for governments as they try to grapple with their burgeoning debt levels.
 
Budget Deficits Surge
Before the financial crisis hit the global economy with full force in 2008, the fiscal situation in the G7 raised few eyebrows. In 2007, the overall fiscal deficit of the G7 amounted to 2.1% of GDP. At the individual country level, both Canada and Germany actually had budget surpluses and although Britain, France, and the US had the largest budget shortfalls, at 2.7% of GDP, they were relatively non-toxic. But, the severe global economic downturn coupled with government stimulus measures aimed at shoring up their respective economies has wrecked havoc on the fiscal situation (see Table 1).
 

TABLE 1

BUDGET DEFICITS

(% of GDP
G-7 2007 2009 2010
United States -2.7 -12.5 -11.0
Canada +1.6 -5.1 -5.2
Japan -2.4 -10.3 -9.8
Britain -2.7 -10.9 -11.4
France -2.7 -7.9 -8.2
Germany +0.2 -3.3 -5.7
Italy -1.5 -5.5 -5.2
Average -2.1 -10.0 -9.5
Source: IMF Fiscal Monitor, May 14, 2010
 
Within the space of only two years, the overall deficit in the G7 has quintupled and reached 10% of GDP last year. All G7 members are now running deficits and the deterioration is indeed eye-popping. The US’s budget deficit jumped from 2.7% of GDP in 2007 to an alarming 12.5% last year and the fiscal situation has also plummeted sharply in Britain and Japan with both economies recording double-digit deficits in 2009. Moreover, with the economic recovery still shaky in many G7 economies, the overall fiscal balances are expected to improve only marginally in 2010. In its latest projections, the IMF expects the deficit to trend higher this year in Britain, France, Germany, and Canada but to dip in the US, Japan, and Italy.
  

TABLE 2

GROSS GOVERNMENT DEBT

(% of GDP)
G-7 2007 2009 2010 CAGR*
United States 62.1 83.2 92.6 14.3%
Canada 65.0 82.5 83.3 8.6%
Japan 187.7 217.7 227.1 6.6%
Britain 44.1 68.2 78.2 21.0%
France 63.8 77.4 84.2 9.7%
Germany 65.0 72.5 76.7 5.7%
Italy 103.4 115.8 118.6 4.7%
Average 82.2 102.3 110.2 10.3%

*Compound annual growth rate from 2007-2010
Source: IMF Fiscal Monitor, May 14, 2010; Chand Carmichael & Co.

 
Getting Buried in Debt
Saddled with substantial budget deficits, the accumulated national debt levels have also been rising dramatically in all the G7 countries. The overall debt-to-GDP ratio has jumped by 20 percentage points rising from a pre-crisis level of 82.2% in 2007 to 102.3% in 2009. Moreover, this figure is projected to climb further to 110.2% this year (see Table 2). For sure, a number of countries began the crisis with high debt ratios and here Japan is the stand-out. With a debt-to-GDP ratio of 217.7% in 2009, its national debt is now larger than the combined annual output of Britain, France, Germany and Italy.
   
While debt levels have shot up in all the major economies, the rate at which the debt-to-GDP ratio is rising varies considerably. As you can see from Table 2, column 4, the overall national debt in the G7 is growing by 10.3% a year. But what is indeed startling is that Britain’s national debt is increasing by 21% a year and that of the United States by 14.3%.

Bond Yields Falling In G7 Economies
Incredulously, despite all the hand-wringing by credit markets regarding the sustainability of zooming deficits and exploding debt-levels in the G7 nations, interest rates on government bonds actually have been falling. Since the onset of the financial crisis, yields on 10-year government bonds are now lower in all the major advanced economies (see Table 3). Moreover, rates have continued to fall despite the debt crisis that has gripped the eurozone economies of Greece, Spain, and Portugal. In these economies, investors, reacting to ratings downgrades and concerned about the risk of default, have sold off government bonds. This in turn has sent bond prices tumbling and pushed up yields. (Bond prices and yields move in opposite directions).
 

TABLE 3

10-YEAR GOVERNMENT BOND YEILDS
G-7 Dec 31 2007 Dec 31 2009 May 25, 2010 YTD % point Chg
United States 4.0 3.8 3.1 -0.7%
Canada 4.0 3.6 3.2 -0.4%
Japan 1.5 1.3 1.2 -0.1%
Britain 4.6 4.0 3.5 -0.5%
France 4.4 3.6 2.9 -0.7%
Germany 4.3 3.4 2.6 -0.8%
Italy 4.6 4.2 4.0 -0.2%
Source: ThomsonReuters; Chand Carmichael & Company Limited
 
This of course raises a key question – why would government bond yields be falling across the board in the G7 when national debt levels are spiraling out of control? It certainly seems paradoxical but there are a couple of plausible reasons for this. First, and most importantly, it is primarily the result of quantitative easing and the aggressive purchase of government bonds undertaken by the major central banks which have helped to hold down rates. Secondly, the recent sharp falls in world stock markets have triggered a flight to safety as investors have flocked to the security of government bonds. As a result, the bond market has rallied sending yields down.  
 
Get Ready for the Coming Bond Bear Market
However, this state of affairs cannot last forever. Indeed, the gigantic financing requirements needed by the G7 governments to fund their budget deficits means that a huge wave of bonds will be continuously coming on to the market place. To put this in perspective, before the financial crisis, the overall deficit amounted to about $630 billion. But by last year, this figure had ballooned to over $3 trillion.
 
As the global economy emerges from its deepest slump since the Great Depression of the 1930s, central banks have signaled that they intend to start the process of ‘normalizing’ monetary policy by withdrawing the ‘emergency’ stimulus measures. As they unwind their quantitative easing policies and scale back on their bond-purchase programs the onus will be on the private sector to digest the issuance of government bonds to fund the deficit. But here’s the rub. With insufficient private sector savings to absorb the ever-growing supply of bonds this means that interest rates have only one way to go, and that is up.
 
One thing is for sure; it is going to take several years of fiscal austerity to bridge the yawning gap between government revenues and spending. As governments start to tighten fiscal policy and lay out their multi-year plans to rein in their budget deficits, to compensate, central banks are likely to keep monetary policy quite lax. While this is the right policy mix to engender economic growth, it may unfortunately prove to be ineffective. The reason; the need to finance persistently high national debt levels by all the G7 economies will lead to rising bond yields.
 
Bottom Line
We may be entering a period where, notwithstanding the intentions of central bankers, monetary policy effectively tightens. The danger here is that a combination of tight fiscal and monetary policy could effectively flatten the recovery.
 
Under these circumstances, investors would be wise to take note that government bonds are no longer the safe haven asset class they once were and it is probably expedient to begin preparing for the coming bear market in bonds which is just around the corner.
 
 
© Copyright 2010 Chand Carmichael & Company Limited

About Ranga Chand
Ranga ChandRanga Chand is recognized both domestically and internationally as one of Canada's leading economists and mutual fund analysts. Professionally, he held senior positions with Canada's Department of Finance, then served as a director of the Conference Board of Canada, before joining a major stock brokerage firm. He has also taught economics at the University of Waterloo, published extensively in the field of economics, and represented Canada at numerous economic forums, including the OECD in Paris, the United Nations, and the World Institute of Economics in .
 
A media personality with a huge following, his popular television show "Talking Mutual Funds with Ranga Chand" aired weekly on Canada’s Report on Business Television (ROBTV) for three years from 2000 to 2003 and reached over 4.3 million viewers nationwide. Much in demand by organizations, industries, and associations throughout
  • Ranga Chand's Top 50 Mutual Funds
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Highly respected in the investment community, Ranga Chand is founder and President of the research and consulting firm Chand Carmichael & Company Limited, located in Ottawa, Ontario.

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