Bond debacle can't be blamed on government debt

The hunt for a scapegoat is on in the financial markets. For quite a time after the onset of the bond collapse in February, investors were content to blame the hedge funds and other leveraged entities for the debacle. More recently, they have started to feel that something more fundamental must be responsible for continuing poor, though now slightly improving, returns from both bonds and equities.

Total returns on global bonds this year have been -8.3 per cent, while global equities have returned only 0.8 per cent. The most frequently mentioned scapegoat is 'excess borrowing' by governments.

There is no doubt that government debt can be crucial in determining the behaviour of individual bond markets. At various times this year, the bond markets of Italy, Spain, Canada and, especially, Sweden have been heavily sold on fears that public debt was out of control.

It will always be the case that extreme cases of high and rapidly rising budget deficits will lead to fears of explosive monetary growth and rocketing inflation, which is one reason why the budgetary tightening introduced last year by the British Government was so vital. But in less extreme cases it has been very difficult to establish a clear adverse relationship between government debt and interest rates. And for the developed world as a whole - the countries of the Organisation for Economic Co-operation and Development - the budgetary situation is not yet extreme. It probably cannot be held responsible for the sharp falls in bond markets this year.

The budget deficit for the OECD area this year will be about 4 per cent of GDP, which is slightly less than it was last year when bond markets were surging. This is no worse than the budget deficit at the trough of the last recession in 1982/83. Nor is the structural component of this deficit - the part that is likely to remain after the recession is over - any higher than it was then.

The OECD's structural budget deficit will actually drop from a peak of 3.4 per cent of GDP in 1992 to about 2.3 per cent of GDP next year, mainly thanks to the budget consolidation programmes in the US, Germany, Italy and the UK. The effects of this sizeable fiscal correction have been somewhat hidden by the ongoing impact of the recession. But in reality, governments have acted much more rapidly in the 1990s to correct their underlying budget imbalances than they did in the 1980s.

From 1982 to 1986, when the bond and equity markets were both surging, the OECD's structural budget deficit remained continuously above 3 per cent of GDP.

In view of this, are there any rational reasons for being worried about government deficits at the moment? There are three reasons for concern.

First, despite the fact that deficits are no worse than last time, the total stock of government debt is considerably higher than it was in the early 1980s.

The OECD economies never succeeded in bringing debt ratios down during the boom of the late 1980s, because annual deficits remained too large compared with the growth of national income. One factor in this was the high level of real interest rates throughout the decade, which led to a doubling in debt service from 3.5 per cent of GDP in 1978 to 6.8 per cent in 1986. This almost exactly offset improvements in other elements of government budgets and kept outstanding debt ratios rising.

The ratio of government debt to GDP in the OECD will rise next year to about 70 per cent, compared with 53 per cent a decade ago. Every major country has suffered a considerable increase, with the honourable exception of the UK, which has managed to keep its ratio more or less flat.

Of themselves, these high debt ratios need not be too worrying, as long as they are controlled soon. In individual economies - Sweden, Belgium, Italy and Canada, for example - debt ratios have caused real trouble when they approach 100 per cent of GDP, and are still rising. Certainly, the global financial markets would really need to worry if the ratio for the OECD area as a whole started to creep towards this level.

The second reason for worrying is that projections for the debt ratio over the next five years do not look too reassuring. The OECD has recently calculated what would happen to government deficits and debts if governments successfully implemented their budget consolidation programmes and if the world economy grew at 2.5-3 per cent per annum for the remainder of the decade.

On these assumptions (shown as the main case in the graphs), the global budget deficit would approximately halve, reaching 1.4 per cent of GDP in 2000. On this basis, government debt ratios would stabilise close to 70 per cent, which should be just about manageable.

But this reassuring picture is extremely sensitive to the GDP growth rate and the level of real interest rates. The 'low growth' scenario shown in the graphs shaves only 0.5 per cent off the main case GDP growth rate, and adds a similar amount to real interest rates, but the result for the debt ratio is radically changed.

Instead of stabilising close to present levels, the debt ratio would rise to 83 per cent of GDP by 2000, and would still be on a steep upward path. Even this could be tolerated by the financial markets if private sector savings ratios remained high and inflation stayed subdued, but a benign result would not be certain.

The third potential reason for concern is that demands for capital from the newly emerging economies outside the OECD area may be on the increase, and this could clash with the capital needs of OECD governments, forcing a rise in global real interest rates. Much is made of this possibility in public debate, but it is highly conjectural whether this will actually turn out to be a problem.

In the past, rapidly emerging economies - such as Japan and the Asian 'tigers' - have typically displayed a voracious appetite for capital, but have also been able to generate most of this capital internally. In these economies, individuals have greatly increased their savings in the early period of industrialisation, so there has been no drain whatsoever on the net savings of the developed economies.

However, the present group of newly emerging economies - China, India, Mexico, Latin America and others - have not so far shown the same propensity to generate all their own savings. At present, the developing economies are sucking in about USdollars 120bn of capital each year from the OECD area.

This is still quite a small figure - equivalent to about half the size of the US budget deficit - and is probably manageable, but it would become a problem if it grew rapidly from here. As more developing economies gain access to private Western capital markets - after implementing programmes of stabilisation and market reform - this is a possibility.

It would be foolish to conclude from this that government deficits will never prove to be a problem for the bond markets. Indeed, they are already proving to be a major handicap for a handful of the most indebted major economies, and many others are poised to join them as problem cases unless governments stick to quite tough spending restraints as the global economy recovers.

But it is equally difficult to blame budget deficits - which, after all have been improving this year - for the bond debacle of 1994. An extraordinary loss of nerve by long-term investors has been the problem, and there have lately been some signs that this is at last beginning to be repaired.