Sovereign Debt: the (Relatively) Good, the Bad and the Ugly

A good deal of the debt related news this month has focused on the sovereign debt issues of Greece, Puerto Rico and Ukraine. All are negotiating for a restructuring of their debt, with their creditors currently playing hardball. I think this is just the beginning of what will be a series of waves of sovereign restructurings. As always with debt issues, the timing of when this occurs is very difficult to predict, but the bad metrics mean it is almost certain to occur in the long term.

The often cited McKinsey paper titled Debt and (not much) Deleveraging¹ highlights the rapid growth of sovereign debt since the last financial crisis. Sovereign debt has grown much faster than corporate, financial and personal debt, and this trend is consistent across developed and developing nations. The general opinion though is that this isn’t an issue as interest are low making the serviceability of the debt relatively easy. As the European debt crisis of 2011 showed, debt servicing is easy until creditors lose their confidence. When that happens, the change can be very rapid and countries using debt to fund deficit budgets rapidly hit a brick wall. It’s pretty easy to generate GDP growth when there’s a lot of debt fuelled spending, the hard part is maintaining that growth when a deleveraging is forced upon a country.

One of the issues that often comes up on sovereign debt is who is a fault when a country defaults? Is the borrower responsible for repaying debts if a former government wasted the borrowed funds? (It generally isn’t possible to say how the funds were spent as government budgets are essentially a pot of funds divided many ways – some better than others.) Is the lender at fault if ex-post analysis shows that there wasn’t a realistic possibility of the debt being fully repaid? These are reasonable moral questions to ask, but as an investor I never want to be caught in these discussions on my investments. If there’s a chance these discussions will happen in the future, the debt should be completely avoided.

To walk through the issue a little more this month I’m writing up my thoughts on three countries of interest, looking at where they stand with their use of debt and the issues they face. I’ve entitled it the (relatively) good, the bad and the ugly as the countries are Australia, Italy and Greece in that order. Australia is only relatively good as it is flattered by the comparison with the others rather than being good on a standalone basis.

Australia: Are We Getting (Financially) Fat and Lazy?

It is often commented that Australia has an obesity epidemic, almost rivaling that of the US. We love calorie rich food that gives us a quick hit and we aren’t doing much exercise. In short, we are getting physically fat and lazy.

When it comes to economic matters things are just as bad for Australian governments. State and federal governments have largely given up on economic reform and are generally content with running budget deficits year after year. The federal government has kicked off a “national discussion” on tax reform but quickly closed the door on many of the most logical and necessary changes. Mike Baird, the most reform minded of the state government premiers has suggested raising the GST, but on the condition that the funds be used to pay for health expenditures and not to lower income taxes. Apart from a few independent senators no one dares to suggest that cuts to unnecessary government expenditure or a crack-down on tax evasion are a better way to balance the federal budget.

The debate over the GST itself is an example of the intellectual stupidity infecting much of the debate. It is commonly claimed that a change to a broad based GST would be regressive, that is it would impact poorer citizens relatively more than wealthier citizens. This is wrong for two reasons. Firstly, some of the tax collected would be used for welfare payments which disproportionately benefit poorer citizens. Secondly, the poorest citizens cannot afford private school education, private healthcare, more expensive fresh food items and international travel. Despite this, each of these areas is currently exempt from GST.

On the welfare side Australia has shifted from a position that welfare is only for the poorest citizens to a system where more than half of all families are entitled to some form of direct government benefit². The 2011 census data had the median household income at $64,344. Contrast this with the changes in the last federal budget that saw the cut-off level for the Family Tax Benefit B reduced from $150,000 to $100,000. The proposed increase to a 15% GST has been accompanied by a suggestion that there should be full offset for households earning less than $100,000. Rather than more welfare, reductions in the income tax rates for middle income earners would be a much better way to encourage Australians to generate their own income and take control of their financial position.

Many CEOs of large listed corporations seem to spend as much time lobbying politicians and participating in “feel good” activities as they do on their core business. In just the last few years Qantas, the car industry, farmers, the tech industry and ship builders have all had lobbied long and loud for special treatment at taxpayers’ expense. We are heading down the same road as the US, where the greatest return on investment available is not from new technology, increasing scale or cost reduction efforts but from lobbying governments. The Sunlight Foundation estimates US corporations received $760 of benefit from every $1 spent on lobbying³. I’m guessing given the amount of lobbying that goes on in Australia the benefit to expense ratio is unlikely to be very different. Governments have long forgotten that every benefit given to one special interest group is effectively a tax on everyone else.

Where Should Reform Start?

I see the need for economic reform as obvious but unlike many others I don’t see the task as too complex or unmanageable. (Perhaps it is my background in restructuring that makes me more optimistic that change is manageable if the problem is acknowledged and the changes are broken down into key parts.) In a big picture perspective the first three areas to begin with are:

Govern for the majority
Reform the tax system
Reassess all government spending

The upcoming National Reform Summit organised by the Menzies Research Centre and Craig Emerson aims to start on at least the first two of these three areas. The idea of the summit is to create momentum for reform by bringing together disparate groups and agreeing a blueprint of key reforms. Rather than allowing special interest groups and politicians to dominate the public discussion, the Summit aims to represent the silent majority of Australians who are willing to compromise in order to see a stronger economy with greater employment and a better tax system.

On tax reform, I recently made a submission to the tax discussion process which you can find here.
http://www.narrowroadcapital.com/memos/submission-on-the-tax-discussion-paper/

The submission walks through the issues with the current system and identifies the four biggest areas of tax reform to focus on. These are:

Income taxes: lower and harmonise income taxes for individuals, companies and trusts and remove special interest deductions and loopholes

GST: broaden and raise the GST

Land tax: replace stamp duty with a broad based land tax

Black economy: compel the availability of electronic methods of payment, substantially increase the penalties for negligent and willful tax evasion, and incentivise individuals to report tax evasion through revenue sharing mechanisms and a tax lottery

As a nation we have become financially fat and lazy, living as though prosperity requires no effort to maintain. The twenty four year run of positive growth since the last recession can’t and won’t continue without economic reform. I’m hoping the National Reform Summit can reinvigorate the process of economic reform and thus help Australia retain a place amongst the wealthiest and fairest countries in the world.

Italy: The Next Domino to Fall in the Eurozone?

In the last six months the inevitability of a haircut on Greek government debt has become obvious with even the IMF putting forward that the current level of debt is unsustainable. Once markets have digested that, the logical question is who will be the next Eurozone nation to default? Portugal, Ireland, Italy and Spain are the main contenders with each having their own issues that could bring them unstuck. Amongst this group, I’m singling out Italy as the weakest, even though the ten year government bond yields would indicate Italy is the second lowest risk amongst the four.

Firstly, Italy’s debt to GDP ratio is the third highest in the developed world coming in behind Japan and Greece. Not only is it higher than its peers at 135.1%, but it is growing at a rapid rate adding 3.0% in the last quarter. The growth in the debt to GDP ratio comes from both budget deficits and anemic rates of GDP growth, neither of which is expected to improve anytime soon.

Secondly, Italy’s banks are amongst the worst performing in Europe with non-performing loans currently at 17% of gross loans and rising. There’s also a substantial pool of high risk loans on the edge of falling into default. The 2014 European Banking Authority stress test found that Italian banks were amongst the least prepared to deal with what was a fairly soft “stress test”. This all points to the possibility of future bank failures and deposit haircuts (think Cyprus) or the need for a government bailout. Either way, the debt/GDP ratio could rise quickly.

Thirdly, the Italian population is the fourth oldest in the world behind Monaco, Germany and Japan. When combined with a bloated welfare state Italy ranks highest in the OECD for pension payments as percentage of GDP at 14%. This is only set to get worse as the fertility rate of 1.4 children per woman is one of the lowest in Europe and migration rates remain low.

Fourthly, Italy remains a hopelessly inefficient and corrupt economy. The government bureaucracy is rated amongst the worst in Europe, the influence of the mafia cripples investment in the private sector and tax evasion is rampant. As Greece has shown, austerity measures alone are not the solution, economic reform is a necessary part of the process of change. Like Greece, there appears to be little appetite for long term reform measures in the short term political cycles.

Despite all of the above being public knowledge, markets aren’t yet pricing in much of a risk in Italian ten year bonds with the premium over German ten year bonds currently 1.15%. This looks like a good opportunity to go short with the aim of realising a substantial gain when markets either reprice Italy as an individual risk or when the spectre of European sovereign debt risk next resurfaces. As Italy’s sovereign debt is double the size of Spain and roughly ten times the size of Ireland and Portugal it is simply too big for Europe to bail out. Those looking to offset the cost of shorting can consider going long Australian AAA residential mortgage backed securities, which are currently paying around 1.10% above the Australian government bond yield.

Greece: a Pause Before the Inevitable?

When I wrote about Greece in April 2014 I rated the prospect of default within a five year period as being at least 50%. I’d now reduce that window down to the next twelve months as the problems seem to keep mounting and what appears to be the inevitable restructuring of Greek debt is being openly admitted. The IMF acknowledged in July that it recognises Greece needs a debt haircut in order to have a chance of reducing the amount of debt it owes relative to GDP⁴. The EU is ignoring that for the time being, but given the IMF is the senior ranking creditor to the EU it is not too surprising that they disagree.

Whilst the framework of a deal has been agreed there are still several major milestones before Greece gets breathing room for another one to three years. Firstly, all governments and organisations involved need to agree the detailed terms and sign-off. Secondly, the situation with the Greek banks needs to be resolved. Thirdly, the spending cuts, tax increases and asset sales need to be implemented by Greece. Each of these is thorny enough, but it is the bank issue that is of most interest to me.

The Greek banks have both liquidity (bank run) and solvency (bad loans) issues. Deposits have been pouring out as Greeks have (rationally) been trying to get their money out ahead of a potential haircut on their deposits and/or a potential redenomination of their deposits to a new, less valuable currency. The ECB has been replacing the funding to the point where its exposure is now larger than the remaining Greek deposits. In the event Greece was to default the ECB would likely suffer a near complete loss on what it has injected. This would see the equity capital of the ECB wiped-out. Whilst markets might be pricing in some of the potential for the Greek deal to fall apart, I don’t believe they are prepared for the possibility of a capital call on all of the remaining Eurozone nations to recapitalise the ECB.

As well as the deposits leaving, Greek banks have been hit with a surge of borrowers defaulting. In March it was estimated that one-third of Greek loans were in arrears, more recent estimates have that as half of all loans. Whilst the quantum of eventual losses is unknowable at this point, it is fairly clear that current provisions and capital reserves are insufficient. To fund the recapitalisation of the banks, it is proposed that Greek assets (think airports, infrastructure, property etc.) will be sold. Given (i) the dire state of economy and (ii) the enormous risk of the assets being nationalised if Greece defaults and exits the Eurozone any asset sales will either be deferred to the medium term or consummated at fire-sale prices. At a minimum the Eurozone nations face a timing risk as the proceeds of the sales won’t arrive for at least months whilst the Greek banks need to be recapitalised immediately.

The inability for Greeks to conduct normal business through the banking system is further damaging the economy. Many transactions, such as wholesale purchases, simply cannot occur or if they do they will require suitcases full of cash. Hospitals and chemists are said to be running out of supplies as they cannot pay their creditors. As a result of the uncertainty and the inability to access bank deposits retail sales are plummeting and that will quickly flow on to further unemployment and reductions in the national GDP. The recently imposed GST increase should have helped government revenue somewhat, but with sales plummeting, transactions made in cash or by people bartering⁵ the amount collected will likely be far less than forecast.

We are seeing a nation economically fall apart in front of our eyes. This naturally leads to the debate about the morality of the debt and this is not a black and white issue. Greece is partly at fault as it didn’t exercise restraint when there was easy availability of debt. It also hasn’t made much of an effort to reform its taxation and spending policies, which has meant that the ability to service its debts is greatly reduced. However, the lenders are also at fault for lending to a borrower that clearly didn’t have fiscal discipline. As an investor, the key takeaway is never to be involved in a situation like this. Don’t lend to governments that aren’t showing fiscal restraint, you are effectively subordinated to the citizens and have little prospect of forcing asset sales.

If you think this will never happen in “normal” Western nations note the recent court rulings in Chicago and Illinois⁶. In both of these cases the governments proposed reforms to pension plans that would have reduced benefits to current and former employees. The courts ruled that this was a breach of contract, which in effect means that the benefits can only be reduced if there is a bankruptcy. As the outcome in the Detroit bankruptcy showed, institutional creditors rank a distant second to the rights of current and former government employees in the event of bankruptcy.

Links Referenced

Australia: Are We Getting (Financially) Fat and Lazy?

Where Should Reform Start?

Italy: The Next Domino to Fall in the Eurozone?

Greece: a Pause Before the Inevitable?

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