Shares fell 2% and more in some cases, commodities were sold off and currencies fell as the US dollar jumped as worries about the YUS economy and European sovereign debt hit markets overnight.
This global blow out in public debt has been a key outcome from the global financial crisis. Aging populations are also playing a role.
The AMP’s Chief Economist, Dr Shane Oliver says that debt crises in peripheral countries, such as Greece and Dubai, probably aren’t enough to create a major global problem and default is very unlikely in key advanced countries such as the US, UK and Japan.
However, high public sector debt and/or measures to deal with it will act as a significant medium term constraint on growth in advanced countries. Fortunately, emerging countries generally have low public debt levels, as does Australia.
Dr Oliver says this is another reason to favour emerging country and Australian shares and bonds over US, European and Japanese shares and bonds on a medium term basis.
The blow out in public borrowing
The blow out in sovereign debt, as a result of the global financial crisis, is proving to be a major issue.
This is already evident in various countries in Europe, with particular concerns that Greece won’t be able to finance its budget deficit and could default leading to contagion to other high debt countries.
But how big an issue is it really?
Which countries are most at risk
The table (below) shows budget deficits and public debt levels relative to GDP for OECD countries and key emerging countries.
Generally speaking, to prevent public debt as a percentage of GDP from spiralling higher, a budget deficit needs to be around 3% of GDP or less.
But many countries are now well above this.
The countries with budget deficits above six percent of GDP last year are highlighted in red.
Developed countries most at risk are:
- Peripheral European countries such as Greece, Iceland, Ireland, Poland, Portugal and Spain – where investor confidence in public policy has tended to be skittish;
- The UK, US and France – mainly due to big stimulus programs; and
- Long term budget deficit country, Japan.
The deterioration in public finances in developed countries largely reflects the severity of the recent recession, which of course has tended to lead to reduced public sector revenues and increased spending.
This is even more pronounced for countries, such as Greece, which were running high budget deficits and public debt prior to the recent crisis.
However, it also has a structural component reflecting the pressures on budgets from aging populations boosting spending on health and pensions.
This is particularly evident in Japan and parts of Europe where labour force growth is already in decline and the population is aging rapidly, but it’s also an issue in Australia – albeit less so – as the third Intergenerational Report highlights.
In the emerging world, there are pockets of concern, but the overall picture is more favourable.
Whereas the IMF is projecting gross public debt in advanced countries to rise above 100% of GDP this year, in the emerging world it is likely to have peaked below 40% of GDP.
Finally, public borrowing is really a non issue in Australia compared to other countries.
The budget deficit is less than half the average OECD levels and gross public debt of around 16% of GDP is trivial compared to an OECD average of 90%.
Upgrades to Australia’s growth outlook suggest budget deficit projections will be revised down, particularly as stronger employment boosts tax revenue.
Why is high public debt a worry?
While fiscal stimulus was absolutely necessary to combat the global financial crisis a year ago, there are four reasons to be concerned about ongoing high public debt levels:
- First, as public borrowing competes with private borrowing it will boost interest rates over time.
- A rough guide is that if budget deficits are 5% higher relative to GDP over time then bond yields will be 1% higher.
- Second, moves to cut public borrowing via tax increases or spending cuts will likely be a dampener on economic growth and could lead to a more volatile economic cycle.
- Third, high levels of public borrowing reduce the flexibility to respond to a downturn in the economy, so it makes sense to cut it as economic conditions improve.
- Fourth, extreme levels of public borrowing can lead to concerns about sustainability, default etc, which if not dealt with can cause losses for investors and a potential contagion to the debt of other high borrowing countries.
It is this last worry that is affecting Greece right now, and contributing to turbulence in global financial markets.
While the Greek government has committed to reducing its budget deficit, there is uncertainty about its achievability and there is concern Greece will not be able to finance its budget deficit or may default.
This nervousness is contributing to fears about other European countries with high public borrowing levels such as Portugal and Spain.
Furthermore, the relatively strong Euro is making life tougher for Greece (and other problem countries in the Euro-zone) because the ‘one-size fits all’ currency is preventing a currency depreciation which would normally be one way to ease the pain.
The situation in Greece could take some time to resolve itself, which along with other problem cou
