Saturday, June 12, 2010



After the Global Crisis, the world moved from relatively short-lived 'hope' and 'recovery' (2009/3 to the beginning of 2010) back to 'doubts' or even better 'debts' as central theme. Greece kept analysts busy not so much because of its own importance, but mainly because of what it could imply for Euro. When analysts and investors started to worry about Greece being the first of a group of nations that might when combined have a further negative impact on the exchange rate of the Euro, the Euro started its free fall. Portugal, Ireland, Spain and even Italy were mentioned. And last week we wrote about Hungary, that also fueled the panic. In the Hungarian case it was the result of new rulers of the freshly-elected Fidesz party trying to make sure that the unhealthy economic situation of the country was made clear right from the start of their new government. In other words: make sure that 'problems' are associated with the previous government so that you can claim more of the reparation and recovery as related to your healthy restructuring afterward. 

In our previous entry we explained that this was a strategy that might seem logical from the perspective of the new Hungarian policy makers at first glance, but given the nervousness of markets it was silly. After all Hungary is part of Euro territory as well.

As we already indicated in that contribution it is time to analyze the debt issue in more detail. IF debt is the problem, which countries might be affected next? And: are the ones that currently figure on the front pages of almost all serious newspapers across the world really the ones that we should worry about?


In and of itself there is nothing wrong with debt. It is a financial transaction between investors and those that need money. As long as the latter have no problem paying back the principal and interest, debt as such is not really an issue. Actually: in periods of low interest rates one could argue that the gap between required rates of return on equity and interest levels might be used efficiently by increasing debt levels a bit. True, this corporate finance style thinking holds for commercial entities who do know already for a long time that leverage can be an instrument when increasing the return on equity. Hedge funds for instance used this approach when creating levered strategies that did do an excellent job at first (2003-2007), but were affected terribly when the Global Crisis struck. And that is the problem with leverage. Which levels are sustainable and provide an efficient increase of return on equities, and which levels imply excess risk?

On the one hand it is a fact that current inflation and interest rate levels are lower than what we were used to over the last decades. It was actually the drop in interest rates to historically unprecedented levels that caused a situation in which bond yields flourished and made Bonds for the first time in ages a reasonable alternative for Equities. When that started to happen - and the group of people grew that were in doubt about trees growing into heaven as far as equity returns are concerned - the sub-prime crisis was a more than sufficient trigger of equity sell-offs even hurting the market climate in countries that were not that much affected by sub-prime.

And it became very clear that markets were not ready yet for a 'new world' in which Emerging Countries could be true catalysts of growth providing sufficient support to the world's economic climate. True, BRIC nations and the Middle East were the  'nouveau riche' in the international financial community but the US and good, old Europe were still leading the pack in the mindset of most Western observers.

So, back to debt and our question: 'how much debt can countries handle?'.In chart 1 we show the average (equally-weighted) short-term interest rate in the US, Eurozone, Japan and UK over time, starting in December 1969.

 Chart 1; ST Interest Rates in Selected Countries
Current levels at a historic low

When interest rates are decreasing, the same amount of debt poses less debt service. Therefore: in and of itself higher levels of debt are not necessarily a problem when interest rates are lower. Commercial firms know this. That is why governments do normally try to stimulate economic activity and growth through making sure that interest rates are not too high. This will increase the willingness of firms to invest in new projects, even when this involves debt financing.

However, the world was changing and the structurally declining interest rates in the world were not mainly the result of government stimuli but to a large extent related to demographic factors. Median ages in almost all countries have gone up substantially, whereas birth rates have come down. Some countries, like for instance Germany, do now have negative population growth. With older people on average having more savings than younger people, the structural pressure on interest rate levels is not that strange. It implies growing supply of funds. On the other hand, an aging population does pose longer-term problems in that a smaller group of workers will have to earn retirement money for a growing group of non-workers. One example: when the Netherlands initiated their often praised pension system in the 1950s there were 4-5 workers for every non-worker. We are now moving quickly to the opposite ratio! Partly this was caused by a shift in focus from wealth to welfare, but to a large extent it was again demographics. When the system was introduced people retired at age 65 and life expectancy was pretty much the same. Right now, most countries in the developed world and even a growing group in Emerging Markets show life expectancies above 75 or even 80.

Therefore: we have to compare debt levels and the cost of debt service with the potential for debt service. And the latter will have to be paid out of wages, profits etc. In other words: we will also have to take a look at economic growth. Lower interest rates are nice, but we have to look at least at the triangle debt LEVEL - economic GROWTH RATES - interest RATES. But we should also take into account that it is far easier to post nice growth numbers from a low base level than it is from a higher base. But in the end, when populations have a higher base level their combined potential for debt service increases. It is easier to cut costs when you have a good standard of life than when things are looking less good. We will therefore also look at real GDP per capita as an indicator of wealth at the population level.

But in a globalizing world it is important to look at how the country is doing internationally. We will therefore also look at the potential of an economy - as a kind of national enterprise - to generate profits abroad. That is: the net balance of exports minus imports. Basically we can say that domestic transactions between people in a country are to a large extent income re-distributions. Nice (or not so nice depending on whether you are the paying or receiving end), but a surplus on the current account implies simply that your economy is generating new money abroad. Money that could be used for debt service.

However, we are not there yet. Globalization and increased interaction with the world will also imply that negative economic indicators like unemployment will pose growing problems for countries that are not capable of giving hope to their poor and/or unemployed. They will therefore have to spend growing amounts of money to ensure that these people are not left out. Money that will therefore not be directly available for debt service or other types of economic restructuring with shorter-term positive effects. Obviously, investments in reduction of poverty will have longer-term positive effects when done properly. But in the short term, especially in periods of nervousness in the markets, investors tend to be skeptical. I.e., give lower relative weights to longer-term potentially good investments than to shorter-term actions to improve the economy immediately.

Last but not least, we will also look at Corruption. When we are talking about measures to do something about the economy, we have to make sure that money spend will really benefit the economy and not end up in the pockets of a happy few that misuses the funds. We use the Transparency International Corruption Perception Index for this purpose. However, one of the problems with this index is that whenever Western companies are dealing with Emerging Markets countries, and some government minister or bureaucrat in the latter country accepts a bribe it will be totally linked to corruption levels in the receiving country even when it is initiated by a firm from a developed country. At LMG we believe that this is incorrect. We will therefore modify the Transparency CPI Index by subtracting the average value for Emerging Countries from the indicator in Emerging Countries and the average value for Developed Nations from the indicator in Developed Nations.

Summarizing: in this contribution we will analyze the countries of the world with respect to the following eight variables:
  1. Debt Levels (the lower the better)
  2. Economic Growth Rates (the higher the better)
  3. Real GDP per Capita (the higher the better)
  4. Interest Rates (the lower the better)
  5. Current Account Surplus (the higher the better)
  6. Unemployment rates (the lower the better)
  7. Poverty (the lower the better)
  8. Modified Corruption Perception Index (the higher the better)
Obviously we could look at more variables, but at least we created a broader macroeconomic approach in our search for 'the next Greece' that markets could focus on. And be sure that 'themes' and 'events' will be more important macro-economically now that growing amounts of money are invested via hedge funds that are 'event driven' or focus on economic themes with short-termism in the media providing additional fuel to such trends. And foreign direct investments have a tendency to also avoid countries that score bad on the aforementioned eight indicators.

We don't pretend to provide you with the most sophisticated long-term economic research study here, but believe that not too many people will question the importance of the factors mentioned.

In the remainder of the study, we will categorize countries in deciles for each of the 8 variables above. 


Classification of the approximately 100 countries in the LMG Emerge database led to the following results.

Variable 1: Debt Levels
When looking at debt levels Greece was indeed a bad story. In terms of ranking its debt of 113.4% of GDP translated into a 96th percentile rank. But the absolute number one was Japan and it is therefore no surprise that Japanese PM Kan warned the country that 'Greek'-style developments were not as unrealistic for the country as some people might think. 

Japanese PM Kan warning his fellow country-men
Japan the next Greece?
We don't think so as you can read in the remainder of this article.

Other remarkable countries in the top (or should we say bottom?) ten percent of the ranking are Belgium, that will have its elections this weekend. It is no surprise that the Flemish seem to support populist Bart de Weever who strongly opposes the wealth re-distribution from Flanders to the French-speaking south of the divided country. About French-speaking: France itself is also part of the highest-debt group! Italy is another member of this group and that is no surprise. But it is remarkable to see that the high debt levels are not anymore associated solely with poor countries in the Emerging Markets, albeit that countries like Egypt, Sudan, and Sri Lanka are also in this group). To illustrate that high debt alone is not a sufficient classifier we like to mention that even Singapore is in this top-10 percent group. And it is clear that no one in the investment world believes that this will be the next big negative story that speculators will focus on. It is therefore important to go from a one-variable approach to a multi-variable one.

Variable 2: Economic Growth Rates
When looking at Economic Growth Rates we see indeed that this variable was also part of the Greek story. They are once again in the bottom-10 percent with the worst economic growth rates. We classified this group using our GDP growth forecasts for the next 3 years. Ireland, Finland, Hungary, the Baltic States, Slovenia, the Ukraine and Venezuela are also not doing great in this respect.

Greece: More a Corrupted Bureaucracy than Tourism Paradise?

Variable 3: Real GDP per Capita
Obviously this variable is more of a control variable, with the richest countries scoring best and the poorest getting the lowest score, indicating that they can be far more easily affected by attacks when speculators 'discover' them. True, the size of financial markets in a country might be an alternative indicator to measure this. We do however feel that internal resistance against restructuring is just as important since images of this will go around the world, providing extra fuel to speculators that something is wrong, and will remain wrong. And when analyzing actions by labor unions across the world we see that attacks on real wages are often important triggers. The lower the real purchasing power the more aggressive the reaction, because people have less to loose.

Strike in Greece

Variable 4: Interest Rates
When looking at interest rate levels in the world, Greece was not doing that bad as they were part of Eurozone. However, with Euro being one of the major currencies in the world speculators knew that although there were maybe other countries in the world that are far more sensitive to speculation, Euro markets are highly liquid and big. So they opted for an attack on a bigger market, (mis)using nervousness in the market understanding that a good, but smaller profit in big scale liquid transactions on European markets was at least as interesting as bigger opportunities on highly illiquid, smaller volatile and risky markets. But this does not translate into us believing upfront that the next markets that speculators focus on will be big again. In the long run, the smaller ones are most affected because speculators could always create a portfolio of weak opponents that combined represent a big-enough deal flow.

Euro: currently not exactly a 'star'

Variable 5: Current Account Surplus
The current account surplus / GDP variable was another one on which Greece scored poorly. The country is indeed in the bottom-10 percent notwithstanding its great reputation in Tourism. Greece posted a deficit of 12.6 percent of GDP when subtracting Imports from Exports. It seems as if the Greeks were borrowing excessive amounts abroad to buy goods and services produced internationally while at the same time maintaining a relatively non-productive huge government bureaucracy domestically. It is obvious that this kind of policy will sooner or later backfire, even when in a structure like the Eurozone that might make it harder to uncover this type of mismanagement quickly.

Greece: What if the Tourists Move the other Way?

Other countries scoring poorly on this variable are Balkan states like Croatia, Bosnia-Hercegovina and Serbia and Middle Eastern/North African representatives like Morocco, Jordan, Lebanon. Remarkable: all countries with tourism potential. It is as if the presence of touristic opportunities introduces slack when it comes to managing the current account balance. Within Africa, Ghana - often praised for its development and indeed recognized as one of the targeted investment locations of China - was a surprisingly poor scorer with a deficit of 15.8 percent.

Variable 6: Unemployment Rates
Unemployment is still mainly a thing of Emerging Markets when we look at extremes. All bottom-10 percent scorers are from Frontier Markets. Therefore: high growth rates in these countries are one thing, but a lot of this will have to go in first establishing a reasonable basis for its population. It can be done - like the successes in some Emerging Nations have indicated recently - but it is a hard struggle that requires a cohesive economic policy. Without it internal turmoil can start at any time, fed by dissatisfied unemployed masses.

Variable 7: Poverty
At first glance, a critic might be inclined to think that Unemployment - our previous variable - and Poverty (i.e. the percentage of population living below the so-called Poverty Line) might basically measure the same thing. If that would be the case a high correlation between the two variables would translate into double-counting of its effect compared to the other variables in our study. 
However, the actual correlation coefficient between Poverty and Unemployment is a 'mere' 0.34 and that is nothing extraordinary in a macroeconomic study. Poverty and Unemployment do therefore not necessarily measure the same thing!

Whereas none of the nations from the MSCI World and MSCI Emerging Markets indices ranked in the bottom-10 percent as far as Unemployment was concerned, three did so when looking at Poverty. Colombia, Peru and South Africa (currently organizing the Fifa World Cup Football 2010)  have income distributions that place them in this lower group. All others are from the Frontier zone.

Poverty in SoWeTo (South Africa)

Variable 8: Corruption
Last but not least, we look at corruption levels. As indicated above we will modify the Transparency International CPI index by subtracting the Developed World average from the individual scores of Developed nations and the Emerging World average from the individual scores of Emerging nations. The LMG Emerge database contains 77 countries classified as 'Emerging or Frontier' and 24 classified as 'Developed'. We used the new MSCI classification, i.e. one in which Israel was recently re-classified as 'Developed'.

Emerging nations score an average of 3.58 on the Transparency Corruption Perception Index. Developed nations score an average of 7.71 (both on a scale from 1 to 10). As stated in the beginning of this article, we believe that this huge gap is to quite some extent the result of the CPI calculation policy. Receivers of bribes are not always the initiators of corrupt deals. That is why we subtract these averages from the raw score and calculate a 'Modified' CPI Index.

Sure, our modified approach might be labeled arbitrary by some. Even semi-academically maybe, but the Transparency alternative (assigning everything to the recipient) suffers from the same weakness and - as we believe - even bigger weaknesses. It is interesting to note that the fact that Greece is once again in the bottom-10-percent does give us confirmation that we are at least on the right track with our approach. Greece's CPI rating of 3.80 indicates that we are dealing with a corrupt country, since this translates to an outcome hardly higher than the Emerging Markets average and far below the Developed nations normal CPI levels. It is actually quite shocking to notice that Portugal and Italy are the only two other nations from our top-50 (i.e. the MSCI Emerging and MSCI World) that make it into the modified corruption bottom ten percent. Countries that were also mentioned as potentially the next Greece!

We wrap things up by presenting three separate lists. A bottom 10 with countries that worry us most per category 'Developed', 'Emerging' and 'Frontier'. The scores in the table refer to the average percentage rank on the 8 variables discussed above. A value above 0.9 would indicate that a country was - on average - part of the all the worst 10 percent group for each variable.

When ranking the countries of the world this way, we notice that the worst scores are generated by Frontier Market countries and that is of course no real surprise. We also see that with our ranking system covering 8 variables it is about more than just debt percentages when looking for the 'next Greece'. The group of 10 Frontier countries at risk contains a country like Sudan with a debt ratio in excess of 100 percent, but also countries like Uganda, Cameroon and Venezuela with no excessive debt but a disastrous economy. Africa's presence with 5 countries in this list is indicative of the fact that the continent still has a long way to go, but that is of course no surprise.

Source: LMG Emerge - ''It is more than just debts''
Poorest scores still in Frontier Markets
(Rank 1 = poorest; 102 = best)

When looking at the Emerging Markets bottom-10 one might be surprised to see a country like Russia in there. After all its debt ratio is relatively low. But other economic indicators indicate that there are definitely quite a few things not going the way they should (corruption, growth, life expectancy, employment, health are just a few). That Pakistan and South Africa are the two countries that receive the biggest question marks when applying our 8-variable methodology is not really a big surprise. India, Brazil and Turkey are definitely far more surprising. We believe that their debt levels around 50 percent are manageable when taking into account the growth potential in these nations.

Source: LMG Emerge
''Mixed Group of Nations''
''India, Turkey, Brazil and Russia on this list,
but the others seem more at risk''

That financial market speculators did concentrate on a country like Greece, the number one in our Developed Markets list, is less surprising than one might think at first glance. True, with a score of 53 the country is only nr 26 in the world. But when incorporating the fact that speculators will translate a safer / larger financial basis in combination with a low score into a more certain bet for short selling, it is actually quite logical what is going on. Emerging and Frontier Markets are characterized by the availability of far less vehicles for speculation, especially on the short side. If you don't really like a country as investor, the only or best thing to do is just avoid it.

With relatively well-developed financial markets, the large amount of European nations in the developed bottom-10 is indicative of Europe remaining a playground for speculators for quite some time to come. It is clear that we believe that it is correct to consider Spain, Portugal and even Italy and Belgium at risk as well. However, after recent measures taken by EU governments we should also look at the UK. The new Cameron government has a debt burden of 68.5 percent that it has to deal with and economic indicators are not that good. We are not saying that the UK could be the next Greece, but it is not impossible that speculators give up speculation against weaker EU nations and move forward to other weak nations. Pressure on the Pound Sterling would in that case be a direct consequence. The poor position of the USA is directly related to the large bailout program of the Obama government when it tried to countervail the sub-prime crisis and we estimate that this will be something temporary.

Source: LMG Emerge
''Our Approach does capture Greece''
''Europe's worries not over yet''
''UK / Pound Sterling better beware'' 

LMG Emerge believes that it is warranted to consider 'debt' a theme notwithstanding the relatively low interest rates. One of the reasons why this is the case is also related to the fact that banks did not translate low interest rates into a big willingness to provide commercial enterprises with investment credits. Especially small- and mid-sized enterprises suffered from this. Banks did basically use bailout funds to improve their own balance sheets. Or even worse: they started - once again - to pay big bonus packages. Selected Emerging countries show better results, but this non-homogeneous group of nations is still incorporating countries that are showing lesser numbers than developed ones. We believe that it is therefore unlikely that the EM leaders can be such a catalyst of growth that Western nations will leave the crisis behind them without going through a period of tough austerity measures.

Europe with its demographic problems and low economic growth will be faced with tough challenges in the year ahead of us. Euro uncertainty will remain, since there are potentially new 'Greeces' incorporated in it. And we are not just thinking of smaller nations like Hungary here, on the contrary it is bigger ones like Italy, Spain and even France that worry us more. David Cameron's government in the UK will have quite some work to do to ensure that short-sellers will not move away from EU into Pound Sterling-denominated securities. And taking into account the position of the UK with respect to the EU bailout plans, one cannot be too sure about the other EU countries helping them out in such a case.

Conclusion: double-dip scenarios are definitely still not impossible, although we are also not too pessimistic yet. All will depend on the actions of governments, especially those in Europe and the US. Close cooperation with the strongest Emerging Market Countries is essential.

Remarkable: Japan did NOT make it into our 'bottom-10 Developed', notwithstanding a huge debt of almost 200 percent. Reasons: first of all, the incredibly low Japanese interest rates; and second, unlike in other nations, Japans huge pension system has concentrated mainly on investments in Japan itself. This has ensured the sustainability of relatively higher debt levels than elsewhere.

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