Default and confidence risk
In the third and final part of a series on Bermuda‘s public debt situation, Nathan Kowalski looks at the factors that can lead to a debt crisis.
“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
Ernest Hemingway, The Sun Also Rises
In the highly acclaimed work by Professor Rogoff and Reinhart called “This Time is Different: Eight Centuries of Financial Folly” they state:
Highly indebted governments, banks or corporations can seem to be merrily rolling along for an extended period, when bang! — confidence collapses, lenders disappear, and a crisis hits.
It's hard to know with certainty what causes this sudden loss of confidence. How can we identify these problems in advance? Michael Pettis has done an excellent job of summarising five aspects that may lead to a crisis. Let's examine each in turn.
1. Absolute debt levels do matter. As discussed last week, when the average rate on the debt exceeds the nominal growth rate of the economy the debt level as a percentage of GDP rises. It's also worth reviewing the debt level as a percentage of revenues. In Bermuda's case this is running at a level of 157 percent. Although, upon first blush this may seem high it is reasonable when compared to most of the developed world. Canada, for example, has a level over 200 percent, the US is over 300 percent and Japan is nearly 700 percent. One may argue that due to Bermuda's less diversified economy and lower taxable base, escalating debt levels as a percentage of revenues is worrisome as it would be impossible to adjust policy to capture as much revenue as these more developed nations.
2. The composition of the nation's balance sheet matters. Two major factors affect this: the level of foreign currency debt and the prevalence of short-term debt. In Bermuda's case, only about five percent of the total debt outstanding is held in Bermuda dollars. A problem would arise if Bermuda was unable to maintain the peg it has with the US dollar. If the Bermuda dollar were to depreciate, the US dollar denominated debt would become more onerous and difficult to repay.
Luckily, this does not appear to be an issue at this time. The key factor to consider is Bermuda's current account situation. As of the last reported figures, Bermuda's current account posted a comfortable surplus of $171 million for the third quarter of 2011. For the entire year of 2011 the current account surplus is trending even higher than prior year's surplus. The state of the current account is crucial in many aspects to the perceived risk of Bermuda.
The other aspect is the composition of maturities. A very short maturity spectrum creates a greater risk of refinancing for a country as it may have difficulty rolling over substantial sums suddenly if confidence evaporates.
Exhibit # 5 shows the maturity spectrum for Bermuda's public debt. The shorter term maturity of $320,000 in 2014 will likely pose a test in the near future. The weighted average maturity is 6.2 years with most of the other maturity repayments occurring in seven years or longer. This 6.2 year figure compares to the G10 average of 7.1 and the 6.2 average for the PIIGS (Portugal, Italy, Ireland, Greece, and Spain). One could argue Bermuda should attempt to extend maturities by offering a longer duration bond issue when marketing future funding.
3. The economic diversity and level of volatility also matters. Typically a country with a very diverse and less volatile economy is viewed as less risky and rates charged on its debt tend to reflect this. Bermuda's economy is not very diverse and has, over time, become more and more dependent on the international business sector and more specifically, the insurance sector. This continues to be a major risk for the country and the nation should diversify itself away from its current industry focus and attempt to add economic exposure to other industry sectors such as technology or healthcare that offer greater long-term tail winds for growth. A major stumble or shift in the insurance industry would negatively affect the Bermuda economy and could be viewed as a negative credit event.
The government has also acknowledged that Bermuda does “suffer from unusually high volatility in our revenues due to reliance on international business services and tourism, and a commitment to being a low-tax domicile to maintain Bermuda as an attractive business venue”. They also concede that the Island suffers from a “structural rigidity” in its budget structure due to a high level of public spending that is locked in place mainly because public payrolls are extremely hard to curb in the short term. These volatile aspects and rigidity in the budget process make Bermuda more susceptible to a debt crisis.
4. The structure of the investor base also matters. Highly levered investors holding Bermuda debt would constitute “weak hands” and could flee at the first sign of trouble. The majority of Bermuda's debt is held by a group of diverse purchasers. It is impossible to gauge their circumstances. Larger pieces of debt are held by New York Life (holds $75 million) and the Bank of NT Butterfield (holds $200 million).
5. The final aspect to consider is the composition of the investor base. Foreign owners are easier to default on and less likely to remain loyal. In Bermuda's case, non-residents hold approximately 90 percent of outstanding debt. Foreign ownership tends to be less patient than more loyal domestic holders.
We acknowledge that our analysis will not seem comprehensive to some. While different than traditional public debt, future government healthcare, pension and social insurance obligations will become another future liability for the taxpayer. We have, in fact excluded this entitlement indebtedness which according to our initial analysis amounts to a very significant portion of the overall debt landscape in Bermuda.
The difference between these debt components and public government debt however, is that they can be reduced with a significant policy response. For example, if the retirement age was to be increased dramatically, say by five years, this would significantly lower the liability of the pension obligation. We realise this tends to be politically unpalatable and difficult to do but it can be done. Public debt, on the other hand, cannot be magically “policy changed away”. It has to be repaid regardless of actuarial assumptions.
We also recognise the interchangeable and dynamic function these liabilities have on expenditures so we are not discounting them. In fact we are gravely concerned with these escalating costs and the significant burden that is being placed on today's younger generation of Bermudians. The math, however, in this area is more complex and subject to a series of other calculations, analysis and a future article.
Our analysis would suggest that at the current time Bermuda's debt situation is not at a crisis level. It is possible to bring the budget back into balance while allowing the economy to stabilise. There is time to adjust spending and prevent further escalation of debt. The adjustment, however, is likely to be painful and will involve a combination of tax hikes and reduced government outlays.
Although we did not cover entitlement programmes in this analysis, it is apparent that funding trends are unsustainable and benefits will need to be reduced and taxpayers will be asked to make increased contributions to these programmes over time.
At the end of the day, the value of government debt must equal the future stream of discounted government surpluses. If at some point, the market feels the future stream of revenues and surpluses is insufficient to service these growing liabilities it will revolt and force up the interest rates at which the country can borrow.
To prevent this from happening, Bermuda still needs a credible plan to bring government spending into balance and a strategy for dealing with ballooning entitlements that are compounding in the face of challenging demographic trends. Ultimately, all these problems are much easier to resolve if government is able to implement policies that stimulate economic growth. Therefore the optimal solution is determining the balance between controlling spending and attracting new business investment.
Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd.
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