Financial position of governments in major advanced economies (2013)

Gross general government debt is the most frequently used measure to compare public debt across countries. The general government sector includes the central, state and local governments, including social security funds. On this measure, Japan has the most highly indebted government in the world among the advanced economies with a debt-to-GDP ratio that is rapidly approaching 250% of GDP. A quite different picture emerges if general government and central bank liabilities are consolidated and assets are netted. This translates into government net financial worth. On this measure, Japanese debt is only 100% of GDP. Net financial worth does not take into account the assets and liabilities of state-owned enterprises nor government equity holdings in publicly-traded companies. Here it worth noting that the gross debt of government-related enterprieses amounts to a mere 13% of GDP in Japan, compared to 52% of GDP in the US. Net financial worth also fails account for non-financial assets owned by the government such as as land, buildings and structures. As of 2010, these were equivalent to 120% of GDP in Japan, compared to 66% of GDP in the US. Last but not least, Japan’s implicit liabilities (aka NPV value of projected increases in pension- healthcare spending during 2011-50 is a mere 34% of GDP, compared to 210% of GDP in the US. The Japanese government’s position does not compare too badly, after all. Naturally, the deterioration of the government’s financial position at the margin (aka fiscal deficits) is of concern and needs to be tackled sooner or later.

Government assets & liabilities (% of GDP)
Source: IMF

Demographic change and government debt sustainability in Brazil (2013)

Brazilian government debt has been declining over the past decade, falling from more than 60% of GDP in 2002 to 35% of GDP today. The current fiscal stance is compatible with a decline of the debt ratio of 1-2 percentage points a year. Gross general government debt, the more widely used indicator for purposes of cross-country comparisons, remains relatively high. But this is to a large extent due to the accumulation of FX reserves by the central bank and sizeable government lending to the state development bank. 

Moreover, even a tangible increase in gross general government debt would be unlikely to cause problems. Assuming, very conservatively, a real interest rate of 7%, real GDP growth of 3%, and taking into account the lower financial return on government assets (mainly FX reserves, loans to BNDES) relative to their financing costs, general government debt could increase by 20-30% of GDP from current levels without jeopardising public-sector solvency. With government debt on a downward trajectory, however, the equilibrium real interest rate is not likely to rise back to its historical average – and each 100bp decline allows the government to reduce its primary surplus by an additional 0.4-0.5% of GDP. 

Over the medium to long term, rising social security and health outlays on the back of aging demographics will put pressure on the evolution of public finances. The combination of a generous social security regime – Brazil spends way more as a share of GDP than other economies with a comparable level of per capita income and is experiencing, at the margin, a more rapid change of its demographic profile – may turn into an increasingly important fiscal challenge over the medium to long term. The net present value of the increase in pension and health-related expenditure exceeds 100% of GDP in Brazil. A rapidly rising (albeit from a low level) old-age dependency ratio combined with generous social security benefits will sooner or later force the government’s hand. 

Source: IMF

Sovereign balance sheets in Brazil and Turkey (2013)

In the early 2000s, both Brazil and Turkey experienced severe financial crises. Currency depreciation and public sector solvency concerns in the context of significant liability dollarisation pushed both countries to the verge of default. Luckily, both countries embarked upon successful IMF-supervised economic adjustment programme under new governments and experienced a decade of solid economic growth. Coincidentally (maybe) both countries have recently been experiencing wide-spread popular protests, albeit for a variety of different reasons. Arguably, the economic stabilisation of the past decade and the emergence of a politically vocal middle class have played a role here. But this is a separate topic. Let’s focus on economics.

The combination of fiscal adjustment and growth acceleration underpinned improving government solvency. In Brazil, net public sector debt has fallen from more than 60% of GDP in 2002 to 35% of GDP today. Gross general government debt - the more widely used indicator for purposes of cross-country comparisons - remains relatively elevated at 69% of GDP. The more limited decline of gross debt is to some extent due to central bank’s sterilised FX intervention and accumulation policy as well as sizeable off-balance financial transactions in the guise of lending to public sector banks. In Turkey, net general government debt has fallen a little faster than in Brazil, decreasing from 70% of GDP in 2002 to less than 30% of GDP today. Gross general government debt has fallen by much more than in Brazil and today stands at around 36% of GDP.

Both sovereigns have successfully reduced their (net) foreign-currency (FCY) exposure. At end-2012, Brazil’s sovereign net FCY creditor position was 14.2% of GDP, compared to Turkey’s 1.7% of GDP. Both countries have largely eliminated domestically-issued FCY(-linked), while a decade ago, 30-40% of domestically-issued government debt in both countries was linked to the exchange rate. In Brazil, the general government domestic debt is 55.8% of GDP, compared to total debt of 58.7% in 2012. By comparison, Turkey’s domestic debt amounts to 28.4% of GDP, compared to a total of 37.6% of GDP. The Brazilian central bank holds FCY assets worth 14% of GDP, roughly the same as in Turkey, translating into net FCY creditor  position in both cases.

A sovereign net FCY creditor position means that, unlike a decade ago, exchange depreciation leads to a decline – rather than a significant rise – in the net debt-to-GDP ratio. Accumulating large FX reserves does come at a direct financial cost, however. First of all, the central bank typically sells government bonds from its portfolio to absorb the additional liquidity created by FX purchases, thus effectively financing lower-yielding FCY-denominated assets by way of higher-yielding local-currency (LCY) government debt. Moreover, to the extent that a currency is undervalued in real terms, reducing net FCY debt deprives the sovereign of the opportunity to reduce the LCY value of FCY liabilities by way of real currency appreciation. Last but not least, the resulting larger stock of domestic LCY debt will tend to help keep domestic interest rates high. 

On the flipside, a large net FCY creditor position (aka large FX reserves) provides the authorities with more ammunition to intervene in the FX market and provide FCY funding to domestic financial institutions and corporates in case of a “sudden shock” (e.g. Brazil in 2008-09). Brazil certainly has a much a more favourable external liquidity position than Turkey. It may be worth noting that the CBRT’s net international FX reserves amount to less than half its reported reserves after adjusting for domestic banks’ FX deposits with the central bank. In practice, this may not make a significant difference, but in this respect Brazil’s position is more favourable, too.

While both the Turkish government and the banking sector can sustain even a large exchange rate shock, limited FCY liquidity means that the impact in terms of higher interest rates, lower local liquidity and economic growth will be much more significant than in Brazil. It is no coincidence that Turkish real GDP declined dramatically in late 2008 and early 2009, while the Brazilian economy only registered a very mild decline in output. Turkey is no doubt more exposed to a sudden stop, and while the government and the banking sector seem well-positioned to withstand significant exchange rate depreciation, the authorities have significantly less scope to soften the impact of such a shock as far as external liquidity is concerned. 

Interestingly, Brazil’s significantly more favourable FCY position does not translate into lower sovereign risk as reflected in CDS spreads. Curiously, as of early July Brazilian 5Y CDS spreads traded at 195 bp versus 180 bps in Turkey. Naturally, Turkey’s gross and, less so, net public sector debt is lower than Brazil’s. But its external position, if not vulnerable, is undoubtedly more sensitive to an external shock than Brazil’s. It looks as if the benefits Brazil derives from a large sovereign FCY creditor position in terms of markets’ perception of sovereign risk are at best very limited compared to Turkey, while it undoubtedly translates into higher (quasi-) fiscal costs. Nominal and real interest rates in Brazil remain significantly higher than in Turkey. That said, large FCY holdings do make Brazil less susceptible to a sudden stop than Turkey. Think of greater quasi-fiscal costs as an insurance premium.

Government debt sustainability in the emerging markets (2013)

Governments in the advanced economies are facing sizeable short-, medium- and long-term debt sustainability challenges. By contrast, government debt in the EM has been trending down due to a combination of solid economic growth, low interest rates and, with only a few exceptions, sustainable fiscal policies. More specifically: gross general government debt is set to remain stable or decline over the next five years, with the possible exception of Russia. But Russia has by far the lowest level of government debt among the top-tier EM and the rise in debt is likely to be negligible. Moreover, if the government’s non-equity financial assets are taken into account, the government is a net creditor. 

If implicit debt is taken into account, a somewhat less straightforward picture begins to emerge. If the implicit debt stemming from the increase in pension- and health-expenditure is taken into account (and adequately discounted), countries like China and Russia, the two countries with the lowest government debt level, begin to compare much less favourably to countries with large public debt burden, like India, but with limited implicit pension- and healthcare liabilities. According to the IMF, the NPV value of spending increases in 2010-50 is in the 200-300% of GDP range for China, Russia, Korea and Turkey, and less than 100% of GDP for India, Mexico, Indonesia and Poland. Naturally, this is not meant to suggest that these liabilities were materialise. Pension and healthcare reforms do take place and fiscal policy can be adjusted to deal with the impending rise in spending and liabilities.

Historically, emerging markets (EM) have tended to get into financial trouble on account of their FCY debt. In addition to a decline in government debt, the share of FCY debt as a share of total debt has fallen in virtually all EM. At the same time, increased FX reserves have substantially reduced – and in many cases – eliminated potentially risky net sovereign FCY exposure of the public sector. The public sectors of most top-tier EM are net FCY creditors. In effect, this means that currency depreciation results in a reduction of net public debt. Many EM have replaced FCY debt owed to foreigners with LCY debt owed to foreigners (thus overcoming the so-called “original sin”).

Source: IMF

Last but not least, while fiscal deficits are quite small, generally less than 3% of GDP (with the significant exception of India), and consistent with stable-to-declining debt-to-GDP ratios over the medium term, gross financing requirements remain large, at least by EM standards. In 2013, they will range from 17% of GDP in Brazil to basically zero in Korea. Both gross and net financing requirements have generally been declining, or at least they have not been increasing, in recent years. In many cases, the maturity structure of domestic debt has improved. Government refinancing risks are very manageable, not least because medium-term debt sustainability and credit risk is generally not an issue. After all, non-resident holdings of government debt in countries with large financing needs are low as a share of GDP – and vice versa. Like in most other EM, sovereign risk is mitigated by manageable underlying debt dynamics, limited-to-non-existent FCY mismatches and the fact that where foreigners make up a significant share of the investor base they tend to hold longer-duration debt.