Despite or because of fiscal austerity: Let´s leave that sterile debate behind and look at the global investment consequences of fragile OECD finances. A graph from the latest OECD Factbook 2013 shows the rise of government debt ratios as a percentage of GDP, from the start of the global financial crisis in 2007 until 2011. In a former blog entry here ( “Role Reversal in Global Finance” ) I had discussed Esward E. Prasad´s (Brookings and Cornell U) presentation at the 2011 Jackson Hole Symposium. Emerging countries, not just China but China above all, hold debt claims against OECD countries that find themselves on unsustainable fiscal trajectories as a result of very, very unpleasant debt dynamics - depressed growth and rising sovereign risk premia. While in the past emerging market investors (and emerging country governments) had mostly to worry about the liability side of public balance sheets, public debt trends in the OECD have now emerging markets worry about their public assets. “Emerging markets dump Euro reserves”, read a recent FT article. Likewise, OECD based widows and orphans should check whether their rents are still funded by toxic OECD government bonds.
OECD General Government Debt, 2011/10 vs 2007
Percentage of GDP
Source: DOI : 10.1787/factbook-2013-en
The recent banking crisis in Cyprus (and before in Iceland) and their “resolution” have now also put the safety of bank deposits in doubt. In an excellent Vox contribution, Anne Sibert discusses “Deposit insurance after Iceland and Cyprus”. The combination of hypertroph banking systems and fragile government finances is lethal for the credibility of public deposit insurance. So OECD countries with sound budgets but oversized banks as a fraction of GDP or taxes (say, Luxemburg or Switzerland) face contingent liabilities, which may also easily exceed their capacity to protect depositors. For Dr. Sibert, the “Cyprus and Iceland lesson is clear:
- Deposit insurance is only insurance for small crises.
- Sufficiently large bank failures or system collapses are a different matter.
In such cases, small depositors are only safe if the sovereign has both the ability and willingness to compensate them”.
Widows and orphans are thus well advised to reorient their assets toward emerging market government bonds. Markus Jäger and Thomas Mayer of Deutsche Bank analyze major emerging government bonds in the (unpublished) Global Economic Perspectives (3rd April 2013). They present a graph to show that foreign holdings of emerging market domestic local-currency has surged; the graph does not present the financially closed Asian giants China and India where foreign holdings of government debt are less than 2% of the total. In Mexico, Indonesia, Turkey and South Africa, foreign holdings of government debt have recently exceeded 30% of the total.
Source: Deutsche Bank, Global Economic Perspectives (3rd April 2013)
There is thus hope for the rents of widows and orphans: The major emerging countries benefit from significantly improved public debt dynamics and pursue policies broadly consistent with medium-term solvency, very much in contrast to many OECD countries. Moreover, local currencies are structural appreciation currencies as long as the emerging countries continue to grow faster than and converge with developed countries, adding another benefit for OECD based investors.
Consider some pull factors. Debt dynamics are favourable in emerging countries as prospective growth rates continue to exceed effective interest cost on government debt, as cyclically-adjusted primary budget balances are in surplus, and as sovereign risk spreads are down with improved investor sentiment and rating scores.
´Original sin´, i.e. currency and maturity mismatches, has been largely deleted as emerging-market banks are not only better capitalized than in the past but have also limited foreign-currency risks on and off their balance sheets; average term to maturity are not yet long in some cases (Brazil, Turkey: ca 4 years), but have considerably lengthened in the past decade.
Unlike in many OECD countries, emerging countries do not simultaneously display high government debt burdens and high private credit as a fraction of GDP. Where private credit shares are high (roughly China 125, Korea 100 and South Africa 140, % of GDP), government debt is below 40% of GDP. Where government debt is relatively high as a fraction of GDP (Brazil 65, India 70, % of GDP), private credit shares are solidly below 60% of GDP.
To be sure, it is not all about assets being pulled toward emerging countries as their debt management has improved. The very expansive monetary policies pursued simultaneously now in all major OECD regions, has generated important push effects. A return to higher interest rates in the US, Europe and Japan would certainly hurt emerging market government bonds as a large part of institutional assets is still invested from there. This would be a buying opportunity, as the emerging-country fundamentals are now more solid than OECD fundamentals.
Orphans and widows would be well served by an ETF invested in a pool of the major emerging country bonds, such as the Barclays Capital Emerging Market Local Bond ETF. (Disclosure: I am invested with 6% of my portfolio).