Borrowed Capital. Debt. Leverage. Once – and once again – these words are all the rage. Every economic cycle some people divine that the secret to success is borrowing money. Well, some people in the countries most likely to default thought 'borrow money at a low hurdle rate, and deploy it at a higher rate of return'. Just soak up the difference, they said.
But then, always suddenly and to no one’s expectation, everything changes.
But it's not just people; countries have been doing the same thing. So which have the most debt and what are the countries most likely to default on it?
What are the countries most likely to default in the next downturn?
We chose to make this call based on the CIA World Factbook’s 2016 information on Debt as a percentage of GDP. This number is a similar measure to the debt coverage ratio we might use to evaluate companies.
1. Japan – 222.20%
2. Greece – 179.40%
3. Lebanon – 146.60%
4. Italy – 132.50%
5. Portugal – 130.40%
6. Jamaica – 127.10%
7. Cabo Verde – 123.90%
8. Mozambique – 121.20%
9. Eritrea – 120.90%
10. Yemen – 119.10%
Where do Canada, the United Kingdom and the United States sit on the list of countries most likely to default?
19. Canada – 99.40%
26. UK – 89.30%
43. USA – 76.50%
Debt is neither good nor bad. In fact, theoretically it leans towards being good. If you or I have a good opportunity and we need to borrow some capital (the ability to command human or material resources), thank goodness we can. And in return, we borrowers compensate the lenders at an adequate rate of return to cover the riskiness of lending to us.
In 1936, John Maynard Keynes published The General Theory of Employment, Interest and Money. In this book he explained that countries could and should operate much the same way in many circumstances. Long story short, when the government spends money, it creates a positive circle of re-spending in the economy, leading to more production. This ought to increase the amount of tax dollars received more than enough to cover the cost of interest on the debt. There are some major differences, but the crux of the argument is that leverage can be used to create positive results.
This model is easiest to understand when you look at allocated government spending. Governments are consistently taking out loans to finance various domestic projects that our politicians campaign on. Think infrastructure spending on new roads, or even state-of-the-art airports. So what does this all have to do with the countries most likely to default?
What gets a country on the list of countries most likely to default?
Stories are the main reason; when the stories we tell ourselves about where the economy is going get pessimistic, we run into problems. Think about it – how much fundamentally changes between an ‘up’ and ‘down’ cycle? The main difference is that people and institutions are less likely to provide (and renew) debt, at least at going rates.
That can be a major challenge because positive (beneficial) leverage can turn into negative (harmful) leverage as soon as the marginal return the borrower gets is lower than the marginal cost of borrowing.
Imagine a situation where GDP growth increases slower than government debt growth. That is exactly what happened – in some way or other – to the countries most likely to default. Is there a way for the countries most likely to default to correct their trajectory?
Certainly if a country’s earnings grow faster than overall debt, for example by higher taxes, the government would be in an increasingly more solvent position. Unfortunately, in most cases the economy does not expand enough to help the government pay their debts, and there is generally little political capital for long-term budget solutions.
Risk Factors: Sovereign Gold and Sovereign Debt.
Most people understand that the price of gold has an inverse relationship with general economic stability. Historically, when countries default, or are at risk thereof, the price of gold tends to increase. In a previous blog post we outlines how and why, as economic uncertainty approaches, many investors take money out of fiat currencies and buy gold. The ensuing demand for precious metals tends to be higher than supply and the price increases.
So what about the countries most at likely to default? What happens is they own gold? What if they don’t? Countries with plenty of sovereign gold to their name will have a much easier time borrowing money and supporting sovereign debt. They also have a means to raise liquid capital rather quickly. The issue lies in the fact that most countries with huge debt ratios have less than substantial stores of gold and other hedges. This situation encourages narratives about the countries most likely to default as less creditworthy. Some people may be able to hedge themselves out of inflationary consequences. However, a nation with diminished access to credit markets will end up in a vicious negative circle until trust can be re-established.
Which of the Top 10 countries most likely to default own gold?
Only Italy and Japan feature on the list of top gold owning countries in the world. Both nations could, if they so choose, sell off some of their gold reserves to finance their huge debt. Italy also benefits from inclusion in the European Union. German support, for example, has made it easier to recover from crises in the past. Still, it is unclear how helpful this will be if long-term debt grows at an unsustainable rate.
In fact, this is precisely what happened in the Greek government-debt crisis. EU help came with strings attached. The European Union required that the Greek government meet certain financial solvency measures within a set timeline. As the Greek government was unable to meet these, due to the lack of political capital for austerity measures, this created discord in Europe and global markets alike. Many high-net-worth Greeks, like their Italian counterparts, now hold a significant portion of their wealth in foreign countries. In doing so, they avoid much negative impact of living one of the countries most likely to default. Note that Greece is number two on the list, at time of writing.
Sovereign Crises and the Price of Gold
In the heyday of the Greek sovereign debt crisis, the price of gold flourished. During this time, experts predicted that Greece would vote to default on all their loans. In doing so, some pundits said, they might be forced to exit the EU. This drew many investors away from Euros and towards gold. In no time at all, gold skyrocketed up to over USD $1600 in early 2013. Fortunately for global markets, Greece chose to remain in the EU and accept austerity measures. While an economic crisis was averted, a domestic political crisis ensued. Unfortunately, the economic crisis was not gone and Greece remains of questionable creditworthiness.
More recently, the United Kingdom – not in the top 10 countries most likely to default – has been responsible for some of gold’s biggest price fluctuations. On June 23rd, 2016, the Government voted to leave the EU. Within 30 days of that eventful vote, the price of gold hit a 5-year high. It may also be wise for gold investors to have their eyes on the current situation in Italy and other countries with growing debt. As we learned from Greece and the UK, gold is incredibly susceptible to any political instability.