Monday, January 2, 2012

A Scorecard For Ranking U.S. Treasury Debt Risk Versus Other Countries

This post provides a scorecard for ranking the risk of the U.S Treasury issued debt versus that of the government issued debt of other OECD nations. There is a simple way to evaluate the risk that investors assign to the sovereign debt of countries in the Euro zone. The yields on the governments' 10 year notes indicate the amount of risk buyers assign to the country's debt. However, inflation rates are such a driving factor in the interest rates for sovereign debt that comparisons between countries outside the Euro zone require evaluating additional factors.

As shown in the chart below based on a proprietary scoring system developed by Doom or Boom the debt risk score for the U.S. falls in between that of Belgium and France. However, as a caveat to evaluating the scores shown below, the inputs are based on  projections from the OECD, and for the most part, the OECD has a very rosy view of likely economic results for 2012.  As shown in the "Change in GDP versus 2011" column below, the OECD  is projecting growth in GDP for most of the OECD countries in 2012. If Europe and/or the U.S. enter into a recession in 2012 (as many expect to happen), the Debt Risk Scores will increase, as the inputs will be higher. My expectation is to that significant deterioration in these scores as will appear as the OECD updates their projections for 2012 once actual data is available.

Sovereign Debt Risk Scores By Country 
(based on OECD reports as of 1/1/12)

There are four factors utilized in calculating Boom and Doom's sovereign debt risk scores.

1) Gross Government Debt as a Percent of GDP
In evaluating the risk of a sovereign default, the metric that typically receives the most attention from the main stream press is the percent of debt to a country's GDP. However, while this metric is a good measure of the size of a country's debt relative to its economy, it does not provide a full indication of the risk of a country's debt burden. The best example of this metric by itself not being a good indication of sovereign debt risk is provided by Japan. With debt that is projected by the OECD to reach 219% of GDP, the low interest rate on Japanese 10 year notes (0.99%) demonstrates that at least for now, Japan is able to sell government debt at prices that do not include any risk premium. However, while Japan is the exception, the Euro countries with debt equal to 120% of GDP or more have experienced increases in interest rates required to sell their debt.  The U.S. seems to be on course to reach this dangerous level of debt to GDP within just a couple more years.

2) Government Debt Interest Payments As A Percent of GDP
The interest cost of paying for government debt (4th column above) may be the most reliable single metric for determining sovereign debt risk. As shown in the case of Japan, total government debt (3rd column above) does not correlate to risk. Governments do not have to pay off their debts— all they need to do is ensure that debt grows more slowly than their tax base so that they can role over the payments. The U.S. debt from World War II has never been never repaid and most likely never will be; it just has become less of a drag on the economy due to inflation and growth in U.S. GDP and increased tax revenues. 

However, the interest payments required to fund government debt eat into the revenue a government has available to pay for services, defense, medical benefits, and pensions. The larger the slice of the revenue pie eaten up by interest payments, the less available for other types of spending. As shown in the above chart, 7.3% of Greece's GDP is projected by the IMF to be required for interest payments. Greece is buckling under the high cost of making these payments and if its debt is not restructured the country will almost certainly default. Keeping debt as a percentage of GDP at reasonable levels is critical a country's solvency.

3) Projected Deficit As A Percent of GDP
It seems absurd that huge deficits of the U.S., Japan, and the U.K., countries are seemingly being ignored as a risk factor by the credit markets based on the interest rates of the 10 year notes. While these countries with their own central banks can print their way to solvency, the inflation risk of loose money policies has magically evaporated.  Thus, deficits as a percent of GDP is only utilized as a minor factor in scoring debt risk as the market does not seem to be giving this factor much weight.

4) Change In GDP
The changes in GDP as the OECD updates their projections is probably going to be the  factor that most contributes to the debt scores being dynamic and changing during the course of 2012. I suspect the OECD's projection are incredibly optimistic. Given that these estimates are suspect, change in GDP is only utilized as a minor factor in scoring debt risk.

Evaluating the Debt Risk Score for the U.S.
As indicated by the low interest rates on U.S. 10 Year Notes of 1.88%, the Treasury is currently able to fund our debt without having to pay a risk factor. The U.S. debt is sustainable for now due to the interest cost of U.S government debt of 2.2% of GDP. However, if the U.S. deficit continues to grow by a trillion dollars per year or if the interest rates required to fund the U.S debt double, then the U.S will join the Euro zone nations in facing a sovereign debt crisis. The +9% deficits as a percentage of GDP that the U.S has been running since 2009 is probably not sustainable for more than another couple of years. The interest expense of funding the U.S. debt could be launched into an upward spiral by either total debt continuing to expand faster than GDP or by an increase in interest rates being required by investors in order to continue funding U.S. debt.

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