Debt’s Global Role

May 18, 2017
Editor(s): Dominic Fischer
Writer(s): Max Ruan, Tharaka Segar, Oskar Dobrowolski

Debt is one of the most important aspects of the economy. Debt helps businesses, governments, individuals, either as borrowers or lenders, grow at a faster rate and achieve greater living standards. On a world scale, greater attention has been given to individual economy’s debt situations especially in the US and in Greece. In order to see the gravity of the situation, we need to understand the level of debt that the global economy currently carries. As of late 2016, it is estimated that the total value of global debt is equal to $217 billion. Typically, we measure it as a proportion of the worlds GDP, in which our total global debt represents roughly 325% of the world’s GDP (Rabouin, 2017). Interestingly enough, that means we incur around $60,000 worth of interest every second! (National Debt Clocks, 2017).

Government budgets on deficit

It often happens that governments spend more money than they earn in a year.  To be precise, 86% of federal governments worldwide ran a budget deficit in 2016. One end of the spectrum is Iceland that runs a 12.50% budget surplus in 2016, whilst at the other end lies Venezuela, currently running on a deficit of 39.90% in 2016. We measure national deficits as a percentage of Gross Domestic Product to have an easily comparable statistic across countries. When we say that Venezuela in 2016 ran a budget deficit of 39.90%, it means that the difference between national spending and expenditure accounted for 39.90% of GDP in 2016 (CIA, 2017).

Now before delving any deeper it is important to outline the different types of debt that exist. How is it that governments can borrow trillions of dollars of debt and it is not completely out of control? That is because there is a difference between government debt and personal debt. As an individual who may have a loan, there is a very real obligation to pay back the principal and interest by a certain maturity date. On the other hand, the government is not like a household. It has different powers – for example, it can issue money. Thus, governments do not have the immediate obligation to pay back its debt. This is because it can be rolled-over by issuing more bonds on top of the bonds that are soon due, something individuals cannot do (Luke, 2011). Government debt is never paid down so when the time comes to pay back the principal, governments borrow more to pay back the old principle. This mechanism drives debt levels up. When debt rises over a certain amount, investors start worrying about the feasibility of repayment and demand higher interest rate to account for the risk they are taking. As a result, interest payments on government increase (Kimberly, 2016).

On the other hand, budget deficit can work as a stabiliser to the economy. When recession hits the economy making businesses and consumers lose confidence, government’s revenue melt and expenses grow through social security, creating budget deficit. Additional money in the economy is a positive demand shock that revives the private sector and thus stabilises the economy. Moreover, deficit can help finance high-value investments such as roads and schools that create a long-time gain for the society (Thoma, 2011). It is important to note that extra expenses should be wisely spent to create a long run benefit.

Looking at Australian budget deficit, we can see that spending has continuously exceeded receipts since 2009 (Trading Economics, 2017). Over the years, as a result of running budget deficit, Australian national debt grew to the size of over $700 billion and continues to increase. This amount is equivalent to $29,000 per capita or 42% of GDP (Australian Debt Clock, 2017).  In the federal budget 2017-18 (2017), the current Treasurer expects to run a budget surplus by 2020.

An introduction to fixed income markets; who do we owe the money?

The functions of debt are principally lending and borrowing. Governments can borrow money to finance their spending by going to the fixed-income market, issuing securities such as government bonds and sovereign bonds. Of course, other participants can also borrow, such as companies. In the fixed-income market, bonds can have different amounts (face value) or different timing of cash flows and period to maturities. Hence, typically the different types of securities are split into short-term (money market securities, <12 months) or long-term (bonds 1 year+). Essentially, when governments borrow money by issuing bonds, they are borrowing money from investors who decide to acquire these bonds.

Governments that have the highest debt-to-GDP ratios (i.e. those most at risk, their level of reliance on debt) are Japan (220.34%), Greece (182.86%), Italy (136.91%) and Portugal (137.28%). (National Debt Clocks, 2017). Governments will regularly run a budget deficit and hence, will need to finance it, but there are other options to going to financial markets to borrow money. Budget deficit means that spending exceeds earnings, while budget surplus means that one does not spend all the money they earn.  For example, to deal with a deficit you could increase taxes or decrease expenditure, but certain consequences such as unemployment, lower future economic growth means that under the right circumstances, borrowing money can be the optimal decision. This is because if borrowing can be repaid, governments can borrow extra to not only cover the deficit amount, but use the extra funds to stimulate the economy (Hayesculleton, 2014).

 

There is limited information about holders of Australian debt, however it is estimated that 60% of all government securities on issue were held by international investors in 2016. It represents a fall in overseas holding from a peak at 75% in 2012. Investors interested in accumulating foreign bond issues mainly consist of central banks and sovereign wealth funds, the state-owned investment funds (Thirlwell, 2016).

 

The mechanics of repayment

After growing a significant $57 trillion since 2007, the world’s debt crisis has peaked at an all-time high of $217 trillion (Zero Hedge, 2015).  Nowadays, all major economies have a higher debt to GDP ratio than the financial crisis of 2007. In 2007, many developing nations had to postpone debt reduction, unable to provide resources for its citizens and repay their debts. (Shah, 2007). Investors drive incentives for developing nations to repay their debts more, as these are considered riskier business ventures. However now when examining each country’s deleveraging capacity, it’s become evident to economists that only developing nations are focussed on paying back their debts. Meanwhile more advanced governments are borrowing more and more, increasing risks which may undermine economic growth (Dobbs, R. Lund, S. Woetzel, J. Mutafchieva, M). The McKinsey report accentuates the decrease in deleveraging rates, as nations will need to think new methods of reducing global debt and monitor risk levels.

Most countries issue sovereign debt to finance their growth, however these sorts of deals can quickly go south. Sovereign debt involves governments lending each other money in foreign currencies, whilst government debt is issued in their domestic currency (Radcliffe, 2014). Before issuing loans, governments evaluate the investment’s risk and stability of the intended borrower. First world countries like the US are considered to carry very little risk of non-repayment, whilst investors are wary of borrowing to developing nations. They’re at a disadvantage as they have higher interest rates due to low credit ratings and have more inexperienced governments. When loans default, the lender generally must renegotiate with the borrower, however this leads them to an economic loss. Debt defaults can be caused by a currency crisis, changes in economic climate and unstable domestic politics. Investors do generally have flexible terms which include incentives to repay, debt adjustments and in extreme cases, debt forgiveness.

Currently, the Institute of International Finance (IIF) reports than government bond and loan issuance has grown three-fold from 2015 to now, with China accounting for $710 million or a total $855 billion new issuances (IIF, 2016). The IIF uses a global debt monitor, which tracks all areas of debt dynamics, bond redemption profiles and key emerging markets. They provide quarterly snapshots of international and national level data, and have identified a growing concern for the overall debt burden, especially the rate at which interest rates are increasing (IIF, 2017). The US Federal Reserve’s decision to raise interest rates by 25 basis points (0.25%) is the third hike since the financial crisis and has been introduced just 3 mere months after their previous hike. This interest increase is set to increase other nations’, including Australia, whose banks receive approximately 40% of its funding from overseas.

Debt is a crucial part of the economy, because it supports economic growth when used in the correct way. A vast majority of governments run budget deficits that add up to the global debt burden. Budget deficits can be a useful tool in getting economy out of a depression, however when this tool is overused it can drive the cost of borrowing up. Governments use money market securities and long term bonds as tools of borrowing money. Most of the Australian debt is in the hands of international investors and even though global debt rose to enormous size, developed countries are not paying back the money yet. Australia plans on starting paying off the debt in 2020 by introducing budget surplus however there are few developing countries that focus on paying off their debt, due to the nature of the national debt being not a focus of governments worldwide.

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, its Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.