The disheartening events taking place in Greece over the past few weeks have been a setback to the global financial recovery. You might be surprised to learn that Greece’s debt-to-GDP ratio isn’t actually the highest in the Eurozone. It’s interesting to compare countries’ debt-to-GDP ratios, and see how dire the situation really is.
The problems in Greece came to the forefront when ratings agency S&P downgraded its debt rating to BBB+ with a negative outlook. As a result, the financial media has put Greece in the spotlight, and its cost of borrowing money has increased. No doubt, Greece has runaway debt. It’s debt-to-GDP ratio is about 108 – 112 percent. It’s a very serious situation and puts some questions on the table as to how the Eurozone would handle a country not being able to meet its debt obligations, or default. There has been speculation Greece could end up in this situation.
When the European Union (EU) was formed, there was a fiscal deficit limit of 3 percent of GDP, but very few countries have honored that. Greece has a fiscal deficit of 12 percent of its GDP, four times the limit specified in the eurozone agreement. When the Eurozone was formed, its criteria also called for a government’s debt-to-GDP ratio to be below 60 percent—which we will see hasn’t been honored either.
Individual EU countries can’t simply print money to get out of this situation, unlike a country like the U.S. or Canada, which can do so in a worse-case scenario. Greece can’t print euros, because the money supply is handled by the European Central Bank. They have to engage in fiscal discipline, and generate tax revenue.
When the debt of a country is downgraded, interest rates, particularly on long-term debt, start to climb, and it becomes harder to service that debt. It’s a good example to see what could happen in the U.S. or any other country where rating agencies have threatened to lower the debt rating. It’s certainly a cautionary example for countries running large deficits.
Debt-to-GDP Ratio
The debt-to-GDP ratio is interesting to compare in a variety of countries. This measure is essentially a measure of financial leverage of a country, and has been viewed as a measure of credit bubbles.
As we see in the table that follows, Greece’s debt-to-GDP ratio is 108.1 percent, according to the CIA World Factbook. Italy actually has a higher debt-to-GDP ratio at 115 percent. Spain and Portugal have been talked about in the media as having similar problems as Greece, but we can see that their ratios are actually lower, and are even lower than Germany and France (considered the “anchors” of the Eurozone).
One of the tricky things about this ratio is that estimates can be inconsistent. The International Monetary Fund (IMF) often has widely different estimates than the CIA World Factbook. For example, the CIA World Factbook shows the U.S. debt-to-GDP at 39.7 percent, but the IMF shows 84.8 percent. While that could be a typographical error, what is clear is that lower ratios are better, and above 100 is pretty serious.
The worst debt-to-GDP ratio is actually in Japan, at over 200 percent, almost double any other western country. Think about that if you want to go long Japanese yen! In Japan, interest rates are tremendously low, which is why the debt-to-GDP ratio has been allowed to expand as much as it has. When countries keep rates low for a long period of time, it becomes easy for them to borrow money.
The U.S. had a debt-to-GDP ratio of 125 percent after the second World War, and got out of debt by growing the economy. To lower this ration, a country must expand GDP (and generate more tax revenue), or exercise fiscal restraint. Canada, for example, has very open immigration policies, and these types of policies can reduce its debt by expanding GDP. However, it’s better not to even let the ratio run up, because the bigger it gets, the harder it is to get under control.
Impact on the Euro
As a result of this Greek tragedy, the euro has plunged to a nine-month low against the U.S. dollar, and on Friday, February 12, was trading around $1.3591. For some historical perspective, when the euro was trading at $0.8228 against the U.S. dollar in October 2000, soon after first coming into being. It moved up to parity when the euro currency came into widespread circulation by 2002. So we can see, in the last decade or so, the euro has actually outperformed many other currencies.
When you have fiscal irresponsibility and disagreements about money policy as we are seeing now, that can erode the currency’s value. The euro and the yen do seem like good candidates to be short right now. However, the euro has been extremely volatile as news events break surrounding Greece and other eurozone countries. If you want to trade the euro, it’s certainly not for undercapitalized—or the faint of heart.
At this stage, it appears there will be some sort of bailout for Greece, although none of the details have been made public yet. You can be certain that Greece, if they are bailed out, they will pay for it. They will be made an example of to deter other countries. Certainly, the markets have been calmed by the prospect of a bailout, so investors will be anxiously watching.
Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.
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