In this article, I will outline the different factors that affect the value of sovereign debt. In general, the valuation of defaultable debt depends mainly on interest rate risk, inflation risk and credit risk. However, these days the main influence – concern – of debt valuations is the credit risk or solvency of the organization. In the rest of the article I focus on the factors that determine the credit quality of firms or sovereign entities.
The goal of summarizing the factors that determine the quality of debt is to highlight the complexity of debt valuations and that the comparative approach people employ due to its simplicity, can give misleading conclusions. This is for the simple reason that it is very hard to find two sovereign entities with exactly the same factor loadings. The factors I am going to give bellow can be separated in many groups.
One separation is between factors that describe the state of the domestic economy and the state of the foreign or world's economy. Clearly, open economies are affected by the foreign or global environment as much as they are affected by their local conditions.
Another separation is between factors whose values are currently known, which describe the current state of the economy, and factors whose values are forecasted based on assumptions, which describe the future path of the economy, the evolution of the insolvency measures or the (in)ability of the organization to repay its debts. The current state of credit quality is measured by variables like the Debt-to-GDP ratios and variants of it. The future evolution of the credit quality of the organization depends on estimates (forecasts) of the growth prospects in the immediate as well as longer term future. The main statistic of this sort is the growth rate. Therefore, in total there are four groups of factors – domestic-current, domestic-future, foreign-current, foreign-future.
One more important factor people look at, that is closely connected with the future estimates of factors, is the velocity or rate-of-change with which these numbers are expected to change in the future. For example, a bad current state which is expected to deteriorate fast is different from a current bad state which is expected to deteriorate slowly; therefore there is time for the policy makers to act.
Bellow I separate the factors only in local and foreign, but one should always have in mind that there are two estimates associated with them; the current, and the future.
Domestic Economy's Factors
Let me start with the factors that describe the state of the domestic economy.
- Debt Statistics: This includes measures like[1]
- Debt-to-GDP ratios
- Aggregates of public debt (net, or gross)
- Aggregates of private debt
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- Growth estimates: Growth is the single most important factor in determining the quality and value of sovereign debt. Estimates of it though depend on a number of other factors and conditions like the type of growth:
- Stimulus packages vs healthy growth: Growth rates can be similar in value between two economies but there can be big qualitative differences between them. For example a debt driven growth is very different from a non-debt driven growth. Also, a growth fuelled by monetary easing, like in our days, is very different from a growth driven by a healthy private sector. For one reason, the government cannot keep injecting money into the economy indefinitely. There is an upper limit in this kind of activity.
- Types of projects: In addition what matters for the long term growth of a country is the type of projects that the public and private sector in this country is undertaking. Here comes the ingenuity of the businessmen and that of the policy makers -- are very important factors in determining the value and quality of the debt. The competence of these two groups of people is reflected in the valuations.
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- Government Spending & Government Investments: Government spending has proven to be one of the most important factors that resulted to overblown debts across all countries. This is shown by the actions many countries take to reduce their government spending in order to bring down their balance sheets.
- Competitiveness: Competitiveness is an extremely important factor that determines the growth rate that certain projects can deliver. This measure describes the ability of the labor force. The more competitive the labor force of a country the higher the growth rate as lower cost per unit of production implies higher output.
- Legislation: The current and expected laws of a country constitute a first order determinant of future growth. The clarity, simplicity and stability of the Laws that have to do with the labor, pensions, and taxes encourages foreign and domestic investments, hence promote output.
- Ethics: Alternative this factor could be called corruption. The business ethics of both the labor force and businessmen is another factor that influences investments. By ethics we mean all the unwritten cultural influences that affect the behavior and attitude of a country’s citizens. Here I also include the tendency to pay or avoid paying taxes, as well as the tendency to conduct business in the underground economy, to collude, and to manipulate the markets. For example, there are clear differences between the ethical standards between Japanese and Greeks, or between Germans and Italians.
- Size: The size of the economy and the history of the country clearly affect the investors’ perspective. U.S. is different from Holland, Belgium and Luxemburg. Even if the fundamentals of these two groups of countries are not very different, the U.S. is considered more stable since its fate depends on the success of many more projects than the success of any of the other countries. In other words, U.S. is a more diversified “corporation”. The same is shown by comparing Japan with Greece. Japan may actually have more debt than Greece relative to GDP, nevertheless, forgetting other factors that are different between the two countries, Japan has way more projects active than Greece. The history finally of the economy is important.
- Emerging or developed: A clear distinction between the world’s economies is between those who are developed or matured countries, meaning countries that have been experiencing a stable economic environment for the last 60 years at least, and developing or emerging markets which have been facing currency and debt crises periodically and still work towards industrialization and greater economic reforms (openness). Emerging markets are associated with greater risk in reversing the growing path they have embarked upon, therefore undermining investments and output.
- People’s psychology: This category wants to differentiate between optimism and pessimism of country’s citizens as well as their attitude towards saving and consuming.
- Exchange Rate Mechanism: An extremely important determinant of future growth and investments is the exchange rate mechanism of the domestic country. Monetary policy is one of the policy tools (the other being fiscal policy) that each sovereign entity has in order to control and navigate the economy. In times of crises, when the country wants to improve its competitiveness, one possible action is to devalue its currency. This is what all the Euro Area countries cannot do now, even though they would like to be able to, like Greece, Italy, Spain and Portugal. Having stable and credible monetary authorities that can act decisively in helping the local economy is a first order factor in determining the quality of a country’s credit.
- Business Cycle Phase: The current phase of the business cycle describes the prospects of the local economy. A booming economy is treated differently than a collapsing economy. The real (fundamental) prospects are different, and also the investors’ psychology is different, between these two cases, blinding them sometimes from easily forecastable problems.
World Economy's Factors
The world economy’s factors are consisted of all the above mentioned factors for all the foreign countries. For example, the other countries’ Debt-to-GDP ratios, the world economy’s GDP growth, the consumers’ sentiment in these other markets, the exchange rate mechanisms in the rest of the world, and the phase of the global market’s business cycle. It is very important for any country what happens in the world economy, as any shock or event taking place abroad can have strong repercussions in the domestic economy. In the current environment of strong links across all countries, no events can go unnoticed. The attractiveness of one country’s debt depends on the relative attractiveness of all foreign countries’ debts.
In the scale of the world’s economy what matters is everything that describes the structure of the global economy. Like, who are the consumers and who are the producers in the world economy; what the phase of different countries’ business cycles are; foreign countries’ balance sheets; foreign fiscal and monetary policies; foreign savings and investments decisions. In addition to the already mentioned factors I would like to highlight the following:
- Correlation of business cycles: The more the local business cycle is correlated with the global business cycle the higher the risks to be priced. In general investors seek positions that can deliver returns as well as to reduce the overall riskiness of their portfolio.
- Correlation of shocks: The higher the magnitude of the correlation among shocks in different markets the higher the priced risk.
- Trade imbalances: Clearly trade imbalances affect the balance sheets of foreign countries and the relative attractiveness of foreign debt to domestic debt. There is a lot of discussion the last months regarding the imbalances between China, Germany, U.S., U.K. and the other countries.
To conclude, as it is evident by the long list of factors that affect the attractiveness of sovereign debt, it is very difficult to make comparisons between the debts of different sovereign entities both today and across time. This also raises a lot of questions about the studies who claim that they have studied phenomena in the past and attempt to draw conclusions about the current time. It is always challenging to account for all the possible different factors that do affect sovereign debt’s attractiveness. Something to always have in mind.
[1] As I describe in Economic Data and Manufactured Confusion there are many seemingly similar measures of debt one can look at. One has to be careful and consistent with the measures he uses.
