When is Federal Government Debt Too Much?

Excessive debt tends to be centre of many scare stories. And it runs something like this “we have lived beyond our means, we await divine retribution”. Global debt has reached USD200 trillion, over 2.5 times global GDP in 2017. The top five countries with high debt to GDP ratios were: Japan (220.8%); Greece (179%); Portugal (138%); Italy (137.8%) and Bhutan (118.6%). Singapore has a ratio of 104.7% and is ranked 10^th.

In 2010, Reinhart and Rogoff (Harvard University) in their book “This Time is Different” suggested that when debt is 90% (or more) of GDP it will impact negatively the growth rate of a country. This was challenged by Thomas Herndon, Michael Ash and Robert Pollin of the University of Massachusetts, Amherst on the basis that the data used was debatable, exclusion of certain items and, there was a coding error in the spreadsheet. The reason this subject is important is not because of some academic spat on methodology but the results impacted policy in the U.S. and Europe. “Austerity” was the catch-word for the Republicans (in the U.S.) and Conservatives (in the U.K.). Reinhart and Rogoff, of course have defended their work with the argument that they were only pointing out an association between debt and economic growth – not necessarily high levels of debt means low or negative economic growth.

Be that as it may, prudent levels of debt will make repayment feasible (from income streams derived from investments). The new Minister of Finance laid out the Malaysian Federal Government debt and liabilities as follows:

Source: The Edge Markets

The RM1 trillion figured touted is not all debt but obligations as well. We need to exclude lease payments which are already included under operating expenses of the Government. Then the Government guarantees of approximately RM200 billion will not be wholly “called” as these are guarantees for borrowings made by Government-owned special vehicles. And these vehicles will refinance their debts (when they fall due) against the same guarantees until income streams cover operating costs and potential repayment profiles. Perhaps, 20% of these guarantees (following Pareto principle) may be called (like for 1MDB) and therefore say, RM40 billion be included as potential realised debt.

What really matters is the sum of RM686.6 billion or 50.8% of GDP. Interest rate, quantum of exposure in foreign currencies and foreign holders of Federal Government debt are the key to any risk. In other words, the risk exposure in terms of currency, interest rate and types of holders of debt is the important issue. Offshore borrowings (in RM equivalent) for the Federal Government were at RM22.7 billion (as at end 2017). That’s less than 3.5% of debt. Interest rates are fairly competitive and are generally below 5% p.a. for either Ringgit denominated or foreign currency denominated papers. Our sovereign rating is still A3 (stable) by Moody’s. That means we still have access to capital markets. That may change with any uptrend in interest rates. But the real problem is foreign holders of Government debt. That constitutes over 28% (or RM194 billion) which is of concern. Why? Because they could potentially “dump” the Government securities and flee. That may cause a market tremor and forex collapse (including BNM reserves). In addition, we may need to keep an “eye” on offshore borrowings by private sector which was over RM150 billion in 2017. Generally, these are against offshore income streams which then are a natural hedge.

So what’s the solution? Borrow if you must but for projects that can provide return better than cost of debt. Secondly, examine existing debt/guarantees against potential income streams of projects. So I would pour through the cash flows of all Government special vehicles with the view to reducing or restructuring debt (including securing fixed rate instruments). Next, is to engage with foreign holders of Government debt and provide timely, transparent position of Government finances.

So what’s the maximum? That’s determined by the debt-service to export ratio which is the indicator of debt sustainability. It indicates how much of a country’s export revenue will be used-up in servicing its debt. A country’s international finances are healthier when the ratio is low. For most countries it is zero to 20%. For Malaysia it is expected to be 5.4% for 2018 (World Bank Development Indicators 2017). For Singapore, it is 9.1%.

Reference:

1. This Time is Different: Eight Centuries of Financial Folly, Carmen Reinhart and Kenneth Rogoff, Princeton University Press.

2. Oliver’s Insight (22 March 2017, Edition 8)

3. Stashlearn (July 2017)