Debts A Problem? Not In Australia

However, high public sector debt and/or measures to deal with it will act as a significant medium term constraint on growth in advanced countries. Fortunately, emerging countries generally have low public debt levels, as does Australia.

The AMP's Chief Economist, Dr Shane Oliver says this is another reason to favour emerging country and Australian shares and bonds over US, European and Japanese shares and bonds on a medium term basis.

The blow out in public borrowing

The blow out in sovereign debt, as a result of the global financial crisis, is proving to be a major issue.

This is already evident in various countries in Europe, with particular concerns that Greece won't be able to finance its budget deficit and could default leading to contagion to other high debt countries.

But how big an issue is it really?

Which countries are most at risk

The table (below) shows budget deficits and public debt levels relative to GDP for OECD countries and key emerging countries.

Generally speaking, to prevent public debt as a percentage of GDP from spiralling higher, a budget deficit needs to be around 3% of GDP or less.

But many countries are now well above this.

The countries with budget deficits above six percent of GDP last year are highlighted in red.

Developed countries most at risk are:

The deterioration in public finances in developed countries largely reflects the severity of the recent recession, which of course has tended to lead to reduced public sector revenues and increased spending.

This is even more pronounced for countries, such as Greece, which were running high budget deficits and public debt prior to the recent crisis.

However, it also has a structural component reflecting the pressures on budgets from aging populations boosting spending on health and pensions.

This is particularly evident in Japan and parts of Europe where labour force growth is already in decline and the population is aging rapidly, but it's also an issue in Australia - albeit less so - as the third Intergenerational Report highlights.

(Big Table here)

In the emerging world, there are pockets of concern, but the overall picture is more favourable. 

Whereas the IMF is projecting gross public debt in advanced countries to rise above 100% of GDP this year, in the emerging world it is likely to have peaked below 40% of GDP.

(first graph here.. much less public debt)

Finally, public borrowing is really a non issue in Australia compared to other countries.

The budget deficit is less than half the average OECD levels and gross public debt of around 16% of GDP is trivial compared to an OECD average of 90%.

Upgrades to Australia's growth outlook suggest budget deficit projections will be revised down, particularly as stronger employment boosts tax revenue.

Why is high public debt a worry?

While fiscal stimulus was absolutely necessary to combat the global financial crisis a year ago, there are four reasons to be concerned about ongoing high public debt levels:

It is this last worry that is affecting Greece right now, and contributing to turbulence in global financial markets.

While the Greek government has committed to reducing its budget deficit, there is uncertainty about its achievability and there is concern Greece will not be able to finance its budget deficit or may default.

This nervousness is contributing to fears about other European countries with high public borrowing levels such as Portugal and Spain.

Furthermore, the relatively strong Euro is making life tougher for Greece (and other problem countries in the Euro-zone) because the 'one-size fits all' currency is preventing a currency depreciation which would normally be one way to ease the pain.

The situation in Greece could take some time to resolve itself, which along with other problem countries in Europe could cause occasional market jitters.

However, two points are worth noting.

Firstly, Greece is not big enough to derail the global economic recovery - it is only 2.6% of Euro area GDP.

Secondly, while mixed messages are so far emanating from the rest of Europe, it's unlikely that France and Germany will allow Greece to default threatening a wider contagion to other Euro-zone countries which in turn could threaten the survival of the single currency Euro.

More significant are the high public borrowing requirements in the US, UK, wider Euro-zone and Japan.

Reversing the crisis related fiscal stimulus will help, but this will only reduce the budget deficits in these countries by around 2% of GDP, which will still leave them at high levels.

Default is most unlikely in these countries given their taxing power, but one way or another their budget deficits will have to be reduced over time or bond yields will rise sharply.

While fiscal stimulus in these countries won't be withdrawn until there is a strong degree of confidence that a rebound in private sector activity is sustainable, eventual moves to cut budget deficits will be a drag on medium term economic growth.

While it's true Japan has been able to run big budget deficits for years without seeing bond yields pushed up, this reflects high Japanese household demand for bonds and two decades of poor growth and weak private sector borrowing.

Japan is hardly a good model to follow!

There are lots of examples of countries in the past that have slashed their public borrowing, including Australia in the 1980s and 1990s.

But it tends to be painful and it may not be so easy with several countries trying to do the same thing at once and with aging populations working in the opposite direction.

Allowing inflation to rise is not an answer - the IMF has estimated that boosting inflation to 6% would cut less than one quarter of the increased debt stock in advanced countries over the 2008-14 period.

While US President Obama's 2010 Budget projects a reduction in the deficit over time, it does entail tax increases for high income earners and seems to be reliant on optimistic economic growth assumptions.

It also projects a widening in the budget deficit in the short term.

With the US recovery still tenuous and mid-term Congressional elections later this year its hard to see the US announcing significant moves to cuts its budget deficit this year.

Similarly in the UK where elections are coming up.

Overall implications

This analysis suggests several implications for investors.

First, the problems in Greece and other small countries are unlikely to derail the global recovery overall, but they could continue to cause occasional financial market jitters.

Second, the public debt problems in Greece and other European countries are negative for the Euro compared to the $US.

Combined with a sluggish recovery in Europe, the bottom line is the European Central Bank will have to run easier monetary policy relative to the US Federal Reserve.

Third, high public sector borrowing requirements, notably in the US, will over time start to put upwards pressure on government bond yields globally.

Fourth, measures to reduce high public debt levels in key advanced countries will likely slow their growth potential, and potentially result in a more volatile economic cycle.

Finally, the lower level of public debt in emerging countries is positive for their relative growth outlook and for emerging market bonds.

This in turn supports a relatively more favourable outlook for emerging market shares compared to shares in advanced countries.

The same applies in relation to Australia's growth outlook & government bonds.