Week 38 - Italy: A Story About a Country with Insufficient Return on Assets

Situation: Two days after the second bailout of Greece, a news article appeared on the front page of the NY Times (2/22/12): “For Greece, a Bailout; for Europe, Perhaps an Illusion.” The article ended by parsing Italy’s sovereign debt, which has reached an awesome #3 on The Hit Parade of the World’s Largest Debtors. It currently stands at 120% of Gross Domestic Product (GDP). ‘Italy is essentially in a sovereign debt trap,’ said Richard Batty, global investment strategist at Standard Life Investments. For Italy’s debt to be sustainable, the country’s economy must grow at a nominal [i.e., not inflation-corrected] rate of 5% a year, or the interest rate on its 10-yr bond must be 3.6%, Mr. Batty estimates. During Europe’s most recent boom period (2002-07) Italy’s nominal GDP grew at an average rate of only 3.6% and its 10-yr bond has a yield of 5% (even with a big rally this year). Mr. Batty is pointing out that a country must grow its economy at least as fast as the rate of interest it pays on outstanding debts.

Mission: Explain to our readers why Return on Assets (ROA), which for a country is approximately equal to nominal GDP, has to equal or exceed the interest rate on that country’s debt. If it doesn’t, the country’s debts can only continue to grow relative to nominal GDP. When private investors lose confidence in a country’s bonds, that country’s treasury will be forced to offer a higher rate of interest on new bonds to attract a different class of private investor, one interested in “junk bonds”. Those new investors then buy insurance, or Credit Default Swaps (CDS), that pay if the country defaults. The country has entered a “debt trap” because soon most of its tax revenues will go toward paying interest on its debt; default becomes unavoidable.

A country’s assets start with its birth-rate. Add to that the educational system that produces the nation’s workforce. Add increased efficiency in delivering a technologically sound education and the result is higher output/hr from the average worker, i.e. a gain in productivity. The growth rate of the workforce added to the growth rate of productivity equals nominal GDP. If productivity declines because of competition from other countries, GDP stalls-out or falls. Mature economies have a demographic problem because the death-rate becomes higher than the birth-rate. This problem can be solved by importing workers with valuable skill sets to boost productivity. Growth of productivity is also slowed by “friction”. There are many examples of friction, particularly professions with high barriers to entry that lock out new workers and prevent new technologies from taking hold, and/or education systems that fail to provide students with relevant skill sets.

To summarize: Italy’s nominal GDP (workforce gains + productivity gains) grows at only 3.6%/yr in good times. Italy has been paying for growth in its workforce and gains in productivity by borrowing money at an interest rate of ~5%. What this means is that Italy can only emerge from its debt trap by growing GDP faster. It can accomplish this by importing more skilled workers and removing friction from its productivity machine. There is no chance that investors will accept a lower interest rate on Italy’s 10-yr bond until that happens. But once it happens interest rates will drop below the rate of growth in nominal GDP, provided the Italian government uses the increase in revenue to pay down debt.

Bottom Line: Return on Assets (ROA) is an accounting ratio that carries a powerful and immutable impact. Not only countries but every family and business must respect its message: Grow revenues at least as fast as the interest rate on your outstanding debt (or don’t borrow money). But one country’s fiscal & monetary situation does not necessarily resonate with another’s. The US economy, for example, has strong growth when emerging from periods of slack because friction is less of a problem here than in almost any other country. Debt/GDP currently is 0.9-1.0 but is likely to fall below 0.85 over the next 3 years--assuming that nominal GDP growth continues to trend at 5-6%/yr and interest rates on 10 yr Treasury Notes continue to trend at 2-3%. The Federal Reserve has promised to continue its policy of Financial Repression through 2014, so those low interest rates “are baked into the cake.” How does this affect you the investor? It means you have been given a strong incentive to take on some risk. Invest in the US economy: borrow for college, start a family, buy a house, open a business, take more interest in stocks. Now is your time.

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