The Debt/GDP Ratio Is NOT Useful. What You Need To Know 3
There is another, more important reason interest expense needs to be used when trying to understand an entity’s ability to sustain its debt.
That is, legally, defaults occur when one fails to make interest payments.
If this is confusing, think of it this way: anyone who fails to make an interest payment is quite likely to be in a financial situation which renders them unable to pay off the full amount that they’ve borrowed.
Therefore, interest payments must be met, which means that the total amount of debt is of secondary importance, at least when considering if a country will default.
That being said, total debt is not an insignificant factor in all of this, simply because more borrowing means higher interest expense.
Consequently, there is an upper limit to how much a country can borrow, but this isn’t set at a fixed threshold or some magical predetermined amount.
Instead, it is the result of two factors: the first being interest rates, since lower interest rates mean lower interest expense, and the market’s willingness to allow a country to continuously roll over its debt.
Going back to the example of Japan and its ~USD 11 trillion mountain of debt, the country would probably have defaulted a long while back if its interest rates had moved higher. But, fortunately for the Japanese government, they haven’t.
Instead, Japanese interest rates have been very low for a very long time. 10y JGB yields have not been over 2% since 1997, and have even ventured into negative territory over the years.
Unfortunately for us, these two realities don’t really add up to a situation that makes intuitive sense.
Why would a country with such an enormous debt load have such low interest rates?
Aren’t interest rates supposed to rise as total debt levels rise because creditors are afraid the borrower cannot sustain such heavy debt loads?
Well, in theory this line of logic makes a lot of sense, but reality works differently, as Japan so clearly shows.
Interest rates are more than just a reflection of how much lenders are willing to charge for loaning their money, they also incorporate borrowers’ appetite and ability to borrow.
As such, low rates could also be a symptom of low or nonexistent economic growth that creates disinflationary, if not outright deflationary conditions.
Both of which have been endemic in Japan for decades.
To be continued…
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