Never was so much owed by so many to so few. Britain's wartime leader, Winston Churchill, was referring to the RAF in his 1940 speech but today those words could be applied to the international debt mountain. If 2011 can be remembered for one issue, it could be the way that sovereign debt forced its way on to the front pages.
The extent to which many countries have increased debt in recent years is alarming with much of the world now reliant on borrowing from China and the Middle Eastern oil-producing nations. The US losing its coveted AAA credit rating in early August occurred at the same time as Europe was struggling with debt problems in Greece, Italy and Spain. Fear among investors rose when the extent of lending by the stronger European countries such as Germany and France to their troubled neighbours brought back memories of contagion, defaults and bailouts.
The result was that the recent months have seen the most volatile period on investment markets since the global financial crisis of 2008-09. Heightened fears saw many global sharemarkets fluctuating in value between 3-5 per cent on a daily basis and currency values and precious metal prices moved in an extreme fashion as safe havens were sought.
Why are so many countries ramping up their borrowing? The economic principle is to take on debt to help generate more growth, just as the factory manager would borrow to buy a new machine to increase sales and ultimately grow profits. The problem is that the growth in debt has exceeded the amount of resulting economic growth generated. The US is a prime example of this trend, as new debt is raised to cover old debt, like someone approaching bankruptcy juggling credit cards to avoid outright default.
Another reason for the growth in US debt is that its pension and healthcare funding programmes are in deficit so it needs to keep borrowing to pay the bills. This problem is likely to get worse in coming years when an unprecedented number of people retire, the baby boomers, pushing projected unfunded social security obligations in the US beyond US$70 trillion ($90 trillion).
The three main global measures of debt are public debt, private debt and external debt. Public debt is owed by the Government and has been incurred on behalf of the people. Private debt, as the name suggests, has been directly incurred by the populace. Some countries have high public debt and low private debt, such as Japan. Others, like New Zealand, have low public debt but high private debt. Some, like Greece, are high in both. External debt is that part of the total debt of a country owed to creditors outside of the country (ie, borrowed from overseas). High overseas debt levels make a country vulnerable to global capital flows and here is where New Zealand is very exposed.
We have external debt representing around 125 per cent of GDP. New Zealand's net government debt is relatively low at 20 per cent of GDP. But where Japan's substantial private savings help to reduce its total debt level, New Zealand's private borrowing comes in at over 100 per cent of GDP. This is of concern to international ratings agencies. We suffered two ratings downgrades within hours on September 30 when Standard & Poor's and Fitch cut the country's ranking over concerns about growing foreign debt, our first downgrade in 13 years.
Of concern is that 54 per cent of New Zealand's total private borrowing goes into housing, the equivalent of 90 per cent of GDP. As a nation, Kiwis are investing in homes to the detriment of growing a wider and sustainable economy. This problem will be exacerbated as we begin to experience the rising benefit costs associated with an ageing population.
Just as private households carrying too much debt need to increase income and/or reduce expenditure, countries need to do the same. Unfortunately, modern democracies tend to foster debt because governments which attempt to raise income (taxes) or lower spending (benefits) find limited support until a crisis point is reached.
The alternative is that lenders can issue more credit or forgive some debt, just as a supplier may do to a valued customer to keep them in business. China keeps buying US government bonds (ie, US debt) to allow its largest customer to keep buying its goods.
The lesson for investors in this environment is to be cautious and understand what they are investing in. People need to show restraint when borrowing for housing and avoid credit-funded consumption. Anyone looking to invest should seek investments that do not carry excessive debt. While it is a time for caution, anyone holding quality assets shouldn't panic and sell into falling markets.
Above all, concerns over global debt levels and periods of high market volatility point to the need for investors to seek advice to make sure the strategies they undertake are consistent with the achievement of their goals.
Let us hope that 2012 is remembered for something else. Economic recovery would be nice.
* Aaron Hing is head of advice at financial services company Perpetual.