Jan 12, 2015
When does too much debt prove crippling for both economies and markets? Investors have a lot to say on this question and are likely to be influential in answering it for Greece and Russia this year, as well as in shedding light on the prospects for several “frontier countries” in Africa (such as Ghana, Kenya, and Nigeria).
As both Italy and Japan have shown, some countries can live quite a long time with lots of debt, as measured by traditional economic and financial indicators, particularly if the repayment maturity profile is not too onerously front-loaded and the private sector has compensating assets.
Matters get trickier if economic growth — the best antidote over time for overcoming high debt — is persistently stuck at low levels. They get a lot more complicated when these conditions are not in place; and even more so if the large debt overhang discourages inflows of fresh foreign direct investments that can help improve growth prospects — rendering the economies more vulnerable to non-economic shocks, be they political or geopolitical.
This is the case for Greece today where debt levels are excessive, composition has shifted to a less flexible form (including large liabilities owed to the European Central Bank, EU and International Monetary Fund), high growth is still elusive, unemployment remains alarmingly high, and “adjustment fatigue” has set in among the country’s citizens and political class. Moreover, the calling of an election for later this month in which the Coalition of the Radical Left (Syriza) is the frontrunner has renewed concerns about a Greek exit (Grexit) from the eurozone.
Alexis Tsipras, Syriza’s leader, is trying to calm such concerns, including by emphasising that, rather than pursue Grexit, his focus would be ensuring a moderation in the eurozone and Germany’s emphasis on austerity. But investors are understandably spooked by the higher probability of an event that could involve major changes to the country’s financial system and exchange rate.
Already, the yield on five-year Greek government bonds has shot up by some 500 basis points in a month to almost 12 per cent. The longer these concerns persist, the greater the possibility that investors will both go on a buying strike and accelerate their disposal of Greek financial assets in inevitably illiquid markets. The resulting financial dislocations would disrupt the country’s financial relationships and undermine the functioning of its economy, making Grexit more likely.
A similar challenge faces Russia due to the impact of sharply lower oil revenues, western sanctions and currency instability. These threaten the country with a deep recession, accelerating inflation, capital and import controls, and capital flight. Unlike Greece, Russia has a substantial foreign exchange reserve cushion of some $400bn that more than covers its sovereign debt.
But this would be spread too thin if used also to protect the currency, counter a severe import compression due to the collapse in energy export earnings, and help corporates meet payments on the debt they have incurred in recent years. The greater the pressure on this cushion, the bigger the risk that foreign investors will starve the country of the external capital it needs to adjust in an orderly manner to the new realities of the global oil markets.
Then there is the case of the frontier markets, where debt has been on a consistent upward trajectory and new bond issuance last year reached a record $40bn, 50 per cent above the 2013 level. These low-income countries have been enticed to issue by the willingness of private creditors to lend at historically low interest rates, as well as the lack of policy conditionality that usually accompanies funds from official bilateral and multilateral sources. A more difficult global economic and financial environment would make these loans harder to sustain at a time when the countries’ developmental needs require support.
Fortunately, there is nothing preordained about all this. There are many historical examples of markets being calmed by the quick deployment of a comprehensive economic strategy that promises growth and jobs, and one that involves a credible commitment to respecting existing financial commitments. But time is of the essence. The longer it takes for the policy stance to catch up, the greater the risk that economies fall victim to fickle investors and dislocated markets.
Source: The Financial Times