Thursday, February 5, 2015

Those mountains of debt (and assets)

A recent report by the McKinsey Global Institute on the increasing amount of debt among advanced and emerging markets made it to the front page of many financial newspapers yesterday (e.g. the FT). The report reminds us that in many countries debt is still going up as a % of GDP, that there is limited deleveraging. The Financial Times offers an interesting graphical tool to compare debt evolution for different countries.

The data is interesting and it highlights the difficulties in deleveraging but, in my mind, it might lead to readers to reach a simplistic conclusion that is not correct: that everyone is living beyond its means, that we are not learning and that this will not end up well.

Let me start with the obvious point: your debt is someone else's assets. The increase in debt as a % of GDP can be rephrased as an increase in assets as a % of GDP. It implies that the size of financial assets and liabilities is growing relative to GDP. That is not always bad. In many cases we think the opposite: the ratio of assets (or liabilities) to GDP is referred to as financial deepening and there is plenty of empirical evidence that it is positively correlated with growth and GDP per capita.

To illustrate why only looking at debt can give you a very distorted picture of economic fundamentals  let me choose a country that best illustrates this point: Singapore. In the graphical tool developed by the Financial Times one can see that government debt in Singapore has increased over the last years. Here is a longer time series from the World Economic Outlook (IMF) going back to 1990.

The current level of government debt is above a 100% (much higher than in 1990) and it puts Singapore in the same league as Spain or Ireland. But here is the problem: the government of Singapore has been running a budget surplus since 1990 (and many times a very large budget surplus).

What is going on? As the government of Singapore explains here, debt is not issued to deal with funding needs but to generate a set of Singapore government securities in order to develop a safe asset for the Singapore financial markets as well as for the compulsory national savings system called the Central Provident Fund. So while debt is very high, the value of assets is even higher and the balance sheet of the government of Singapore looks very healthy.

This is admittedly an outlier among governments, most governments do not have assets that equal in value their liabilities. But even in those cases someone is holding government debt. And it might be that government debt is held by its own citizens that are in many ways the shareholders of the government. So the consolidated balance sheet of the country might still look great (e.g. Japan). 

This argument does not deny that the actual composition and ownership of assets and liabilities matters (even if by definition they always have to match). We know well that certain credit booms are indeed associated with crisis so worrying about debt is a good idea. But one has to be very careful interpreting analysis (and newspaper headlines) that only refer to the debt side of the balance sheet. A richer analysis that understand where the assets are and how they relate to issuance of debt is necessary.

Antonio Fat├ís