“It was out of control — it was going up more than $200 million a year….you can get to a tipping point — and once you get past that, it’s virtually non-stop down to Third-World status.”— Bob Richards, Bermuda’s former Minister of Finance, discussing the island’s debt in an article from The Royal Gazette, headlined “Richards: we hauled island ‘back from brink’”, December 12, 2017.

We first wrote about Bermuda’s escalating debt problem back in 2011 in a piece titled “Let’s talk debt”. In that article we discussed Bermuda’s alarming escalation in government debt and the need to reign in this fiscal imprudence in order to prevent any future financial calamity.

We cautioned that 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 country’s borrowing costs. Since then the level of debt and the interest costs have essentially doubled.

So has the OBA “hauled the island back from the brink”? The OBA team took office in December of 2012 so let’s use the March 2013 government year-end as the starting point. Let’s also assume an ending point as the 2017/2018 national budget estimates given they set the tone for this period and the budget.

The table attached shows how the fiscal situation has evolved since 2013.

Based on these figures we would suggest that the prior administration has actually done a commendable job of reversing the dangerous course the island was on. From a primary account deficit of about $370 million dollars to a surplus of about $50 million is no small feat.

Furthermore, driving the primary account deficit as a percentage of gross domestic product of about 7 per cent to a primary account surplus of about 1 per cent of GDP is a huge positive swing.

Although it would be disingenuous to suggest this was all the hard work of government restraint and fiscal prudence — the economy healed and grew 12 per cent over this period — it still would suggest actions taken did help to arrest and slow the sizable expansion of the deficit and in turn the trajectory of the island’s debt profile immensely.

Now what?

We would suggest, however, that the job is far from done. Even as we write it would appear the estimated time frame to balance the budget is being pushed out. Public-sector wage hikes and the decision not to implement the goods and services tax — albeit a positive development — will likely make balancing the budget more difficult barring any major economic expansion.

But there is some good news. With absolute bond yields sitting at multi-decade lows and spreads over US Treasury securities also extremely tight, refinancing conditions are rarely more favourable.

The attached table shows upcoming debt maturities, rates and annual interest rate costs.

Readers may note that 2019 offers a potential opportunity to significantly lower the weighted cost of debt if the Government is able to refinance at coupon rates near today’s prevailing market yield for Bermuda government debt.

Assuming the debt level is kept in check and yields do not jump considerably by 2019, it could be possible to refinance relatively close to the current Bermuda ten-year bond yields of 3.5 per cent. This would save the island nearly $6 million in interest costs alone.

The reward for continued fiscal discipline could be a much lower level of servicing costs and, as a result, far greater flexibility for the island if faced with any unforeseen negative events.

We would suggest that the current government should consider taking advantage of Bermuda’s improved financial position and attractive bond market conditions to refinance some of higher coupon debt in 2018 if cost effective.

Blue skies in sight

What this means is that we actually are in striking distance of arresting future indebtedness and placing Bermuda on a more stable path. You may recall the formula that we have described previously, determines the possible point at which the debt level stabilises in terms of the size of the economy.

The inflection point tends to occur when the average interest rate on the debt exceeds the countries’ nominal growth rate. When this occurs, the debt-to-GDP ratio will automatically increase unless the country runs a primary budget surplus. A primary budget surplus is the budget surplus excluding interest paid on the debt.

The economic equation can be thought of like this:

(Average rate of interest on public debt — Nominal GDP growth rate) x Public debt as a percentage of GDP = required primary surplus

Currently the weighted average interest rate, from the table above, stands at roughly 4.6 per cent. This has the potential to marginally improve over time assuming credit ratings remain stable and yields do not rise significantly.

In prior articles, we have calculated Bermuda’s future growth potential. Our analysis suggests a negative 1.4 per cent labour force population trend, primarily due to demographic challenges, offset by an assumed 1.4 per cent positive change in productivity. The result of this prior exercise has allowed us to come to the conclusion that Bermuda’s current real GDP growth prospects look weak and we have suggested that its potential future real growth given current assumptions is 0 per cent. This is not a nominal figure so one will need to add an assumed future inflation rate to this to ascertain an estimated nominal growth rate.

In reviewing the historic inflation rate in Bermuda, and being aware that historic patterns do not necessarily equate to future patterns, we have found that over varying periods of five to ten years this rate tends to be about 2.5 per cent.

This analysis takes into account the GDP deflator rate and Consumer Price Index rate. As a result, we feel it is reasonable that Bermuda’s future nominal growth rate in GDP could run at about 2.5 per cent (calculated as 0 per cent real plus 2.5 per cent inflation).

On the debt side, we roughly have $2.48 billion in net debt on a nominal economy running at about $6.2 billion. Thus debt to GDP stands at roughly 40 per cent.

Taking the components as calculated above, we can derive the primary budget surplus that the Bermuda Government will need to run in future years to maintain the current debt level:

(4.6 per cent - 2.5 per cent) x 40 per cent = 0.84 per cent

What this essentially tells us is that the Government can stabilise the debt level at its current ratio by running a primary budget surplus of 0.84 per cent. The good news is that we are actually there. If the primary account surplus (the surplus before debt servicing costs are factored in) does, in fact, come in at roughly $50 million, we will be at the point at which the debt level as a percentage of the overall economy has finally begun to level off.

Storm clouds receding

We are becoming more optimistic on the fiscal picture for Bermuda but it is heavily predicated on a few major caveats. If the prudence and fiscal consolidation mantra introduced by the prior government is not continued and fostered, the debt trajectory could once again turn for the worse.

We would continue to remind the Government that Bermuda does suffer from unusually high volatility in our revenues due to reliance on international business services and tourism, along with a commitment to remaining a low-tax domicile to maintain Bermuda as an attractive business venue.

The island suffers from a “structural rigidity” in its budget structure because of 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. New programmes, schemes or policies that do not factor in corresponding revenue streams or cost savings (preferably) would derail prior budget work.

We also assume that Bermuda’s economy will stabilise – essentially oscillating around its longer term nominal growth rate of about 2 per cent to 3 per cent. If recent tax changes lead to pressure on our largest industry, anti-money laundering and antiterrorist financing reviews are unfavourable or technological acceleration leaves Bermuda woefully unprepared or irrelevant, we would not be able to maintain the current stable rate. In fact, the fiscal situation could deteriorate rapidly.

This is all the more reason to get to a position of fiscal strength, in order to weather any potential future adversity. For now, we see the clouds beginning to part…but storms blow in quickly for our little island.

Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd and the views expressed are his own

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