Markets & Economy

Text size: 


Global debt: Numbers tell just part of the story

April 28, 2014

Numbers don't tell the whole story when it comes to a nation's borrowing.

Comparing a country's debt to its gross domestic product (GDP) may mean something very different in one nation than it does in another, even when the numbers are similar. The sector in which debt is incurred also matters.

"The risks and opportunities are likely to play out differently in China than they do in Europe, the United States, and elsewhere," said Charles J. Thomas, an analyst with Vanguard Investment Strategy Group."While knowing the numbers can be instructive, it's important to know the story behind the numbers too."

Debt levels around the world, by sector, as a percentage of GDP

Debt levels around the world

We caution readers against making concrete assessments based on this general analysis, as the level of debt that a given country or sector may be able to sustain involves many factors. China's government debt is shown on a gross basis; all others are net. Data show the latest available quarterly value in 2013 as a percentage of the trailing four-quarter average nominal GDP.

Sources: Calculations by Vanguard based on data from the International Monetary Fund, European Central Bank, Thomson Reuters Datastream, Moody's Analytics, Australian Bureau of Statistics, Reserve Bank of Australia, U.S. Federal Reserve, Bank for International Settlements, and Bank of Japan.

The U.S.: An easing burden

While borrowing and spending historically have boosted growth during economic recoveries, in the last few years both governments and consumers have reined in borrowing.

Charles ThomasIn 2009, amid the global financial crisis, the U.S. budget deficit soared to 9.8% of GDP—its highest level since just after World War II—but fell to 4.1% of GDP in fiscal 2013, according to the Congressional Budget Office, which projects it could drop to 2% by 2015. Such fiscal belt-tightening slows economic growth as the government reduces spending on goods and services.

"Governments at the federal, state, and local levels have focused on deficit and spending reductions for the past several years," said Mr. Thomas, one of the authors of Vanguard's economic and investment outlook. "With fiscal balances now at more sustainable levels, these cutbacks are expected to ease over the next year or so, with government becoming less of a drag on growth."

At the same time, consumers' focus on paying down mortgage balances appears to be waning, Mr. Thomas said. Rising incomes and asset values let many households spend more on goods and services and less on debt reduction. This is a positive sign, he said, because spending drives economic growth.

Partly driven by acceleration in consumer spending and easing of government cutbacks, the U.S. economy is expected to grow at a 2.9% annual pace over the next four quarters. That would be up from a 2.2% pace in the three years through 2013.*

But much depends on how the U.S. Federal Reserve approaches its withdrawal of economic stimulus. The private sector debt-reduction and fiscal belt-tightening of the last few years have created high unemployment with low inflation, prompting the Fed to aggressively promote growth. As debt-related economic headwinds ease, the central bank must walk a fine line, Mr. Thomas said, removing stimulus quickly enough to discourage inflationary pressures but not so quickly as to choke economic growth.

Many observers worry about long-term U.S. government debt, which at around three-quarters of U.S. economic output is historically high.

"A key question is how much debt the U.S. economy can sustain," Mr. Thomas said.

"The United States is the world's largest economy, with deep and liquid financial markets and solid institutional credibility. Other countries have experienced pressure with debt at these levels, but the reality is that the market is pricing U.S. Treasuries according to their risks and giving a clear signal that those risks are low right now. We look to policymakers to lower the trajectory of government debt, but this is a long-term issue and there's time to get it right."

Europe: Slow deleveraging

Deleveraging—working off excessive debt—plods along in Europe, where national differences in growth, unemployment, and inflation prevail. How nations borrow and use their borrowed funds differs too.

Europe's debt troubles arise from several countries' use of a common currency, the euro, without adequate integration of fiscal policy.

"The common currency has masked a lot of ills that countries didn't have to address," said Biola Babawale, a London-based analyst with Vanguard Investment Strategy Group.

Countries with very different rates of growth and competitiveness formed the currency union without a way to correct imbalances between them. Over the last decade, accelerated borrowing in Greece and Italy (through the government sector) and Spain and Ireland (through the private financial system) contrasted with debt reduction in Germany.

Biola BabawaleThe global financial crisis exposed these imbalances, and the markets began to re-price nations' relative risk. The debt troubles threatened the euro's existence for a time, but strong policy action and commitment to the euro, especially within the European Central Bank, has made a breakup less likely over the last few years, Ms. Babawale said.

But damaging political flareups remain possible until longer-term imbalances are addressed. The rise in popularity of "euro-skeptic" political parties has fanned fears that European Parliament elections in May will tilt toward anti-Europe candidates and scupper attempts at fiscal integration.

"With such flareups in political risk and populist sentiment," Ms. Babawale said, "any attempt to reform the economy risks being thwarted."

"Markets respond with volatility to these flareups," Mr. Thomas added. He pointed to how the debt crisis that threatened banks last year in Cyprus—an island nation of just more than a million people—drew international attention despite the nation's small size. The bigger implication, he said, was the potential for financial contagion resulting from European banks' lack of a supervisory and resolution mechanism.

The currency union's longer-term imbalances need to be addressed, Ms. Babawale said. The lack of banking union and fiscal integration makes it difficult for businesses and households to pay off debt as markets price risk differently across the euro member countries.

"With interest rates elevated in peripheral nations such as Portugal, Ireland, Italy, Greece, and Spain, savings rates remain low and unemployment high," she said.

Policymakers have made strides. For example, the European Central Bank became the single supervisor of E.U. banks in November 2013. And much has been done to harmonize regulation and tax policy across the euro nations, allowing for further integration of economic activity.

"The structural reform agenda in Europe will take time," Ms. Babawale said,"but it's likely these reforms will produce a more integrated and balanced euro-area economy."

China: Reforms top the agenda

All eyes are on China as the central government considers greater freedom for banks to set their own lending rates amid a transition to a market-based economy.

The worry, said Alexis Gray, an Australia-based analyst with Vanguard Investment Strategy Group, is that some borrowers could default if lending rates were to rise quickly and they couldn't roll over their debt.

Alexis Gray The government-influenced low rates that households earn on bank deposits prop up some corporate borrowers, Ms. Gray said. When an interest rate cap is eventually lifted, depositors will earn a higher rate that recognizes the risk they've been taking. If the return that corporate borrowers earn on their investments isn't sufficient to roll over debt at a new, higher rate, defaults could result. It's not clear what percentage of loans could be affected.

"That's why China is so slow to reform its banking system," she said."They don't want to precipitate a debt crisis. While it's possible that this process exposes some weakness in the financial system and prompts volatility in the markets, this is a necessary step if China is to become more open and integrated with the global economy. Despite the short-term risks, this is a positive development in the long run."

China's nonperforming loans as a percentage of total gross loans

Government debt

Source: Vanguard, using World Bank data through December 31, 2012.

Japan: Paying it down

Japan, the world's third-largest economy behind the United States and China, is still working through debt acquired before the housing bubble burst in 1990.

The question, Mr. Thomas said, is what is a sustainable level of debt for a developed country such as Japan with a currency rate set on global foreign exchange markets?

Partly driven by disappointing economic growth and low inflation, Japan's debt has been high for decades, Mr. Thomas noted. But its high domestic savings rate gives Japan a sizable market in which to sell. The debt is easier to maintain because it doesn't rely on foreign capital, Mr. Thomas said.

Ms. Gray added that the Japanese government's cost of borrowing could jump if markets became concerned about their ability to repay debt. But this scenario seems unlikely for now, she said. Japan is trying to halve its budget deficit between 2010 and 2015, Ms. Gray said, and to balance its budget by 2020.

These targets will be more easily achieved if Japan can increase economic growth and inflation, because higher growth means higher government tax revenues, which can be used to pay down debt. This is precisely the goal of "Abenomics," the policies named for Japan's Prime Minister Shinzō Abe. The faster an economy grows, the less burdensome debt becomes.

Australia: Household struggles

Compared with many developed nations, Australia's government debt levels are relatively low. Australia hasn't had a recession since 1991, which has meant solid tax revenues for more than two decades. The mining sector in particular has provided strong support to the economy in recent years.

Australia also avoided the type of public-sector bailouts that many countries faced after the global financial crisis.

Australia's challenge is its household debt. A savings rate of around 10% deteriorated and temporarily went negative as credit growth soared in the lead-up to the global financial crisis

"That shock renewed Australia's commitment to savings," Ms. Gray explained."People get scared and change their behavior."

Despite the change, household debt levels haven't fallen far from their peak. If joblessness were to rise amid a downturn in the economy, households could come under stress, Ms. Gray said. But with the government on solid fiscal footing, policymakers have room to counteract any weakness in the consumer sector.

Implications for investors

Investors should understand that markets price a country's bonds according to the risks that influence that country's debt and growth. While political and economic events can quickly change markets' perceptions of the value of a country's or sector's debt, these events are difficult to predict in real time.

Despite these risks, over time, bonds as an asset class have generally played the role of "anchor" in a balanced portfolio, buffering the risk of equity investments.

A simple tool is available for investors concerned about the debt and interest-rate volatility of any particular region: diversification.

"By owning a globally diversified mix of investments," Mr. Thomas said, "you may benefit from positive surprises in some countries potentially offsetting some of the downside in others. A diversified global bond investment, assuming currency risk is hedged, can play a valuable role in a balanced portfolio by helping to offset the risk and volatility of the equity market."

* Expected growth is the average median quarterly growth rate for the next four quarters from the Q1 2014 Survey of Professional Forecasters from the Philadelphia Federal Reserve. Trailing three-year growth is from the U.S. Bureau of Economic Analysis.


  • All investments involve some risk, including the possible loss of the money you invest.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks, including country/regional risk and currency risk.
  • Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
PrintComment | E‑mail | Share | Subscribe