There has been much coverage of the economic problems of Greece in the past few weeks. However, Greece is not an isolated case, even if there are a number of factors at play that makes the country’s situation particularly dangerous. On the contrary, what is happening in Greece reflects a development that investors should take very seriously and that could have a significant impact on the behaviour of the financial markets in the coming years, namely the massive deterioration in public finances. This development calls for some comments.

- Government debt is at an historically high level (at least during peace times). This situation is especially worrying in light of the fact that in many countries, the ageing of the population will further increase pressure on public spending in coming years (unless there is a change in the pension systems);

- The government debt problem is particularly worrying in the industrialised countries. Developing countries are in a much more comfortable situation.

- Most of the industrialised countries are affected. In the 1990s, countries like Canada, Finland and Sweden experienced serious problems in their public finances – today the problem is widespread. According to Willem Buiter, chief economist at Citibank, more than 40% of world GDP is generated by countries where the budget deficit currently exceeds 10% of GDP. (It is worth highlighting the fact that Canada, Finland and Sweden have managed to resolve their problem by cutting public spending and today are amongst the least indebted countries in the world);

- In many countries, the high level of debt in the public sector is coinciding with a high level of debt in the private sector. As the economists Carmen Reinhart and Kenneth Rogoff say in their book, "This time is different" ⁽¹⁾, when assessing a country’s outlook, it is total debt that must be taken into consideration. In many countries, total debt has reached a level that, in the past, has led to crises, defaults or inflation.

It is still too early to know how this high level of public debt will impact financial markets exactly, especially since much will depend on the measures taken by the authorities and the speed of implementation of such measures. However, a number of conclusions can already be sketched out:

- The high level of debt will weigh on growth. In their book, Reinhart and Rogoff say that once a country’s public debt exceeds 90% of GDP, its growth rate shrinks by around 1%. Now the International Monetary Fund states that by 2014, public debt will exceed 100% of GDP in the United States, the United Kingdom and the eurozone. The easiest way to cut the debt ratio (public debt / GDP) – have the denominator increase faster than the numerator, in other words, through robust economic growth – seems to be less and less of an option for these regions;

- Unless they react quickly, some countries could even enter a vicious circle, similar to what is happening right now in Greece. Loss of investor confidence in their ability to honour their debt could lead to a rise in medium- to long-term interest rates (over which the monetary authorities have no direct control) in these countries. Servicing the debt would then become very costly. In many industrialised countries, more than 10% of public revenues already go to servicing the debt, despite the current low level of interest rates. If rates rise, a more significant share of public income would have to be used to service existing debt (which would make cutting public spending even more painful);

- From the above, it also follows that the theory whereby it will be increasingly tempting for governments to resolve their debt problems through inflation is too simplistic. The bond markets are very aware of this risk and would penalise any sign of a return to printing money by driving up long-term interest rates. Moreover, in many countries, a high percentage of public spending is directly or indirectly linked to inflation;

- Reinhart and Rogroff suggest that the authorities could however try to maintain a low level of long-term interest rates by obliging financial institutions to buy government bonds through, for example, new prudential measures imposed within the framework of a re-regulation of the financial system. By creating a forced demand for their bonds, they could make it easier for themselves to refinance their debt;

- The book by Reinhart and Rogroff also shows that seeing governments default on their debt is nothing extraordinary from an historical point of view, and that it is more the lack of such defaults in the past few years that should astonish;

- The bond markets should, in light of this, make a greater distinction between countries and penalise those countries whose public finances are regarded as being unsustainable. Canadian research provider BCA Research recently analysed 22 industrialised countries using criteria such as economic structure, monetary and fiscal flexibility, debt burden and dependence on foreign capital. According to their criteria, seven of the soundest countries are Norway, Switzerland (which is nevertheless running the potential risk of having to recapitalise its banks), Sweden, Finland, Austria, Canada and New Zealand. At the other extreme, we find UK, Italy, Spain, Ireland, Portugal, Greece and Iceland;

- It may also be likely that in the future, certain high-quality corporate bonds could become less risky than their home countries and that the distinction between 'government bonds' and 'corporate bonds' would lose much of its importance;

- A low-growth environment, high levels of public debt, a latent risk of deflation or inflation, or a payment default is at first sight not favourable for the stock markets. It should be pointed out, however, that compared to consumers and governments, the financial health of many companies is in good shape. With money-market rates close to zero, these companies could return to favour with investors and even start to play a role of safe haven. The investment themes of ‘quality companies’ and ‘dividends’ should therefore not be overlooked;

- Finally, from the above, the conclusion is that an increasing part of an investment portfolio should be oriented towards Asia and the developing countries which have much lower debt levels and a much higher growth potential.

⁽¹⁾ Carmen M. Reinhart, Kenneth S. Rogoff: This Time is Different – Eight Centuries of Financial Folly (Ed. Princeton University Press)