Management schools teach that in order to obtain lowest cost of capital and highest returns from funds it is prudent to use leverage in capital structure. Higher the amount of gearing, higher is the return albeit at higher risk. Moreover, the operating environment is assumed to be that of continual growth and rational business decisions.
It is also known that a given amount of money creates value that is many times over its face value when it goes through debt transactions between multiple parties. However, default by one party increases the risk of contagion of default by subsequent borrowers. The crisis is often compounded by the dismal state of public finances and dysfunctional political systems
This is aptly reflected in current state of the world economy. Consider a few statistics related to major economies; Overall debt comprising of household, government, financial and non-financial debt as a percentage of GDP stands at 495% for the UK, 492% for Japan, more than 300% for each of France, Spain, Italy and Switzerland, 288% for the US and in the mid 100s for India, China and Brazil.
While the relative statistics for the UK and Japan appear to be the most troublesome, the fiscal and political situation in the US and Euro zone has made high levels of debt a bone of contention in these regions. In absolute terms, US have a debt of USD$ 14.3 trillion, of which 67% is held by private investors and the rest by government accounts. Financing of wars in Iraq and Afghanistan, expensive social security programs and bearing the cost of bailout packages to banks and mammoth corporations rendered nearly bankrupt due to the subprime crisis have been major causes of the enormous debt tab run by the US.
Additionally, the country’s obligations require it to raise further debt which can be done only once the debt ceiling is raised by the congress. However, the current administration’s incapability to arrive at a timely debt deal with the opposition and planned spending cuts cost the country its AAA rating in the bond market. This has created turmoil in the financial markets across the world. The downgrade will cost US economy dearly. Its immediate impact will be record rise in yields on US treasury bonds and subsequent rise in interest cost, which already stands at USD$ 250 billion per annum. This will further worsen the deficit and inflate future debt requirement.
Similarly the Euro-zone is facing a crisis of a ‘debt abyss.’ Some of the countries in the Euro-zone, namely, Portugal, Ireland, Italy, Greece and Spain (PIIGS) are finding it difficult to even service their debts. In this region the problem is as much of heavy indebtedness of these countries as of financial interconnectedness. Greece came to the brink of default as it borrowed and spent way too much than it had ability to pay back. A culture of tax evasion, unaffordable welfare measures, debt-ridden public enterprises and cooking books up until the point where none of these was possible anymore, brought it to a situation where it had to be bailed out by other countries of the European Union. Now Italy seems to be heading the same way. The European Union is in a fix as to whether to bear the cost of excesses of its members to make the Euro survive or to abandon it altogether.
This is the third time in global history that the world is finding itself facing a situation of high indebtedness across developed countries. The first was right after the First World War and the Great Depression. It took bouts of hyperinflation and default lasting for over two decades to get out of the debt crisis. The second was post Second World War. This time the war was financed through an innovative blend of capital controls and exchange rate that forced public savings into government coffers. The debt was paid back over a long time, during which inflation reduced the real payouts by the governments. However, this time none of the above solutions is feasible. The rich world is plagued by recession, heavy welfare expenditures, political deadlocks and people unwilling to tolerate austerity.
The theatrics around debt are raising pertinent questions across the world. US treasury bonds once thought to be the safe haven which companies would use to back up their investments and developing countries would invest their foreign exchange reserves in, are turning out to be risky. Investors are heading to Swiss and Japanese bonds which are considered to be comparatively safer. However, even these countries have high debt to GDP ratios and may not be as safe as thought. In fact there are very few places where the investors can place their money. In the backdrop of the Euro-zone crisis, debt ceiling hyperbole of the US and its subsequent downgrade, it is easy to conclude that the world economy is on a downward spiral. The developed countries will either turn to emerging economies for their huge consumer base or take the route to default.