Consider two countries: one with high public debt and Net Foreign Liabilities rated Baa2 versus one without Net Foreign Liabilities rated Ba1. History has shown that high levels of indebtedness greatly increase financial risks to creditors as investor sentiment becomes more volatile and repayment costs balloon. We believe the risks of this greatly increase when Net Foreign Liabilities exceed 50% of GDP and are typically unsustainable beyond 100% of GDP. Yet there are numerous examples across the world where countries with high levels of indebtedness are rated higher than net foreign creditors or countries with appropriate and sustainable levels of debt. Why is this?
The obvious answer is that financial metrics are not the only measure of investment risks. Political and institutional strength are also key; both of which for a long time have driven higher credit quality and lower borrowing costs for 'developed economies' in comparison to countries considered 'emerging markets'. But how quickly can such political and institutional structures vary for good or for ill, particularly in developed economies? And when they do waver how quickly can this affect credit quality and market sentiment?
For the last half century the political and institutional strength of most advanced economies has proven relatively stable on the back of broadly comfortable levels of peacetime growth; so much so that it can easily feel like this should always be the case. Up until 2016 that was; right before a Eurozone financial and migration crisis, Brexit and Trump et al. Now it seems such institutional resilience should no longer be considered implicit just because the country had its industrial revolution one or two centuries ago. So what happens now to those heavily indebted nations which previously received favourable borrowing costs but no longer show greater political stability in the face of swarming popular unrest?
In a recent report titled 'A Spotlight On Rising Political Risks' Standard and Poor's hinted at their cautious view of this changing environment stating, 'it may no longer be possible to separate advanced economies from emerging markets by describing their political systems as displaying superior levels of stability, effectiveness, and predictability of policy making and political institutions.' Of course rising political risks are not exclusive to advanced countries in the months ahead but what is different is that markets are less used to factoring in such uncertainty for countries like the U.S., U.K. and France.
The first of the two countries we were considering at the outlook was Italy and the second was Russia. On the same day as the aforementioned report, Moody's changed its outlook on Italy to negative following the rejection of constitutional reform and breakdown of current leadership. Yet remaining 2 ratings notches above Russia does not seem to reflect the real potential of Italy electing a 'Five Star' (in name only) movement to take the helm of a vulnerable economy with little experience, or the likely prolonged political inability to push through the necessary ongoing economic and fiscal reforms. Without these reforms Italy’s net debts could soon reach unsustainable levels.
From a credit investing perspective Russia seems the more attractive investment. Not only does it offer a more attractive yield for 10 year debt in comparison to Italy (4.4% in USD vs 2.3% in EUR for the BTPS) but it has shown recent adaptiveness and ability to the lower oil prices and sanctions. In light of Russia's recent announcement of increasing its FX reserves (see yesterday’s daily) and potential for relaxation of sanctions an upgrade seems forthcoming and with Italy's negative outlook and deteriorating financial and institutional strength a downgrade perhaps seems likely in 2017. So for two countries that could very well have the same rating soon we far prefer the one with a higher yield and greater potential for price performance.