As everyone ponders how all economies move into the next phase of Covid-19 - some in the financial markets are starting to think about, how are the shutdowns going to be funded and what will need to be funded?

There is no doubt that most Governments of the world took drastic action to protect their citizens and any cost of that protection was not considered at the time. This was an entirely appropriate response, but it will have dramatic long term implications.

To assess, first, let’s look at the various starting points. How much debt did countries have at the start of the crisis?

The last column on the Bloomberg table below (Figure 1) compares debt-to-GDP across developed markets.

Figure 1: source: Bloomberg

These number are enormous … and they are the starting point.

As a global borrower, it is important to know who owns your debt and why do they own it?

In the case of Japan, ranking number one on the Bloomberg table, - a vast percentage of their debt is owned by locals, either citizens, or institutions, whereas in Greece, coming in second, the debt profile was owned by hedge funds and institutions, which caused much heartache for the Greek people.

What next?

All governments will need to issue debt to fund their obligations to their citizens. When you read “citizens” intellectually substitute the word “voters”, because the present crisis might be a circumstance where “I vote, I need work” could be the next bumper sticker.

In order to imagine how governments can respond to voter concerns, it might be best to understand what they themselves will be dealing with.

Debt to GDP is the countries’ debt (numerator) as a percentage of GDP (denominator). What should analysts assume the denominator will look like for 2020? What about even 2021 right through to 2025? There are over 30 million unemployed in the US in one month.

Who can, with complete confidence, decide what the GDP will look like for any country?

The employment numbers will rebound as economies open, but the reality is that no one really knows at what velocity; what will the bounce in activity look like? Will consumers consume, comfortable that all will be good, no recurrence in pandemics, and that companies will continue to put employee and customer welfare before profits?

I think it is reasonable to presume the denominator will struggle to grow for the foreseeable future, remembering for most investors a month can hold a lifetime of investing experiences, so a five year horizon is the equivalent of a Star Trek light year.

The numerator

This is where the rubber really hits the road because we have been told by Treasury what to expect for upcoming issuance.

The US Treasury announced on 6 May, that its funding requirement for the next quarter is $96 Billion, for one quarter! By President Trump’s own estimate they have the economy contracting this year by 40%; the American deficit will groan onwards to $4 trillion. These numbers are easy to write but nearly impossible to comprehend.

As you try to imagine the size of the US financial commitment - then overlay it, with the needs of Europe, Japan, China, Latin America and the rest of the world.

Why does funding deficits matter?

America, particularly under Donald Trump’s leadership, is not a “cap in hand” borrower. There seems to be very little diplomacy. Think back to the GFC and then Treasury Secretary, Hank Paulson flying to China to assure the Chinese investors that Fannie Mae and Freddie Mac would redeem their debts even if the government had to step in. Fannie Mae and Freddie Mac are the funding entities that provide funding for mortgages in the US.

There is no evidence on the surface that America recognises that it might have any challenge funding $4 trillion in debt … remember those debt ceiling arguments during the Obama Administration?

If there is an investor boycott in any form, then we could see a significant steepening of the bond curve … “Houston, we have a problem!”, America will either cut spending, hurting voters, or raise taxes, hurting voters and companies, or pay the higher coupon on the bond and hope the economy rebounds, which is assuming a very weak US Dollar.

I don’t like any of those strategies and this is all based on the assumption that $4 trillion is enough to kick start an economy that wasn’t increasing in headline revenue prior to the Covid-19 pandemic.

What do investors do?

Australia is not in as precarious a situation as most other countries, as Figure 1 highlights.

I don’t provide advice, personal, investment or otherwise. With these circumstances, I can see a situation that investors may need to take different risks where cash rates are so low predominantly in the short end. Investors who decide to buy long dated government bonds will have revalue risk. The theory is if rates go higher after you invest, there will be a capital loss if you sell that bond in the market. This is a critical issue for fund managers, but if rates in the short end go to zero or lower, then that is a critical issuer for savers.

Therefore, it could be valuable to decide if a part of your portfolio is dedicated to income, and if so, is there a long-dated bond that can meet your requirements?

Again on the premise that I don’t provide any advice, but discern as a keen observer, I would watch to see how markets are responding to the increased issuance - and if you can achieve a compelling rate taking Australian government risk, then it is at least worth exploring through your own independent research or via a fund manager.

Mark Todd

Head of Fixed Income, Bank of China

Bank of China has a commercial interest (in the assets) printed in this article.

Bank of China does not provide investment or personal advice.

Investors should seek its own independent and appropriate advice that is suitable for their investment needs.

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Biplav Adhikari

Great Read!

Roger P

" and any cost of that protection was not considered at the time. This was an entirely appropriate response, " I do not agree that failing to consider cost was ever appropriate at a national level - it is what they are paid to do to run this nation and was always a responsibility. Consider this - why was a life worth say $1M last year and $100M this year? Neither the intrinsic value of human life and what we can justify making other people pay to save it never, ever, changed (given economic chaos due to the choices made there is an overwhelming argument we can afford less - this was never a war, it was a health crisis - no different to anyone else staring down the barrel of a bad test result for say cancer etc today). People love to be heroes - and anyone can be for five minutes of fame, but it is when the full consequences have been learned over time that you can assess if they were heroes or zeroes and that review is a long time away. IMO far too many media opinions are from those that didn't significantly suffer other than at a cosmetic level ie have travel freedoms restricted. Try telling anyone that had a business and lifetimes work destroyed basically to protect the very elderly this was a reasonable response - it was a very unfair reaction in the context that the the real burden in terms of financial destruction was actually born by a very small number of people and it is a fair question if that was a morally correct choice to make. If it you were told you had to hand over a lifetimes work and your home to save a stranger 75 years old - would you? Is everyone else prepared to take say a 15% increase in tax just to compensate those that were wiped out so pain is FAIRLY suffered across the board? Be honest - and if your answer is yes, noting is stopping you donating that amount today.

Alasdair Wardle

Here is a better explanation, by John Kelly in AIMN "money has been, or would have been, created out of thin air by the RBA. THAT IS HOW ALL FEDERAL GOVERNMENT SPENDING IS MADE. It is not borrowed, nor are taxes used. To offset spending that exceeds tax receipts, as a guard against inflation, The Australian Office of Financial Management issues a bond tender which, under normal circumstances, is purchased by individuals, banks, super funds, foreign interests and others. For the buyers of bonds it is no different from buying shares or opening a term deposit. Bonds are issued for a set period, one year, two years, three years and on maturity are retired to the bondholder’s deposit account with the RBA. It is an automatic process and has nothing to do with our grandchildren. The RBA just moves the money from one account to another. As of today, 23rd May, 2020, the AOFM has $649.2 billion of bonds on issue. The last $100 billion of these bonds were purchased by the RBA. They had to do that because no one wanted to buy them. To suggest that this money has to be repaid is to say the government is borrowing from itself and must repay itself. I’m sure you can see the absurdity of this suggestion. Federal government bond issues ARE NOT DEBT. A Federal government currency issuer CANNOT owe itself money. Please stop perpetuating myths.

Mark Todd

Hi Roger your robust response is understandable, I didn't clarify why it was entirely appropriate, my point is that the "costings" are rarely every accurate, just think about the present job keeper numbers as an example. In my view it is appropriate to respond to the crisis, rather then agonise over the potential costs, as in the funding costs! In terms of strategy and the implications for people, business and the community at large I am not in a position to opine, my expertise is in the funding arrangements not the moral arrangements, though I have views I don't see this as a forum to share my views but I absolutely see it as your right to write whatever you may want.

bryan mcmahon

wow —great observation but you left out china and usa in table. no comment re risk of worthless wheelbarrow of paper money

mark holder

@ ROGER P your response is what many people think. Thank you "protect the past to destroy the future " As a retiree, I see no point in the panic and hysteria that has gripped the world. I hope we learn next time to protect and isolate only those in need.

Ron P

A very thought provoking article. Thanks Mark Is this right? US 2020 deficit approaching $4 Trillion ($3T in Covid stimulus so far) US debt (accumulated deficits) circa $25 Trillion US 2020 GDP forecast $20.5 Trillion US total stock market capitalisation $30 Trillion US debt to GDP worst it's been since WWII ( Don't think Buffet would like these numbers.

Mark Todd

Hi Alasdair, I understand your scenario, I think the credit worthiness of Countries to repay their obligations implicate many facets of life, FX rates, cost of borrowing, ability to borrow, we see this play out all the time, Greece, Argentina and so on. That was my point, not so much perpetuating a myth around ownership. For the record the RBA buys the bonds to impact rates not so much because no one will buy Aud Bonds. The AOFM are an outstanding team and the manage the credibility of the Australian Bond curve with consummate professionalism so I think we are in a good position whoever owns the securities. Thanks for the comment

Mark Todd

Hi Bryan the US is in the chart, it is 82.30% Debt to GDP, I only used developed markets, in emerging market data China is 47.80% Debt to GDP, and regarding the Wheelbarrow, we won't need it unless the child cries out the King has no clothes and investors believe him/or her. Thanks for commenting

Mark Todd

Hi Ron, the numbers are enormous and it relies on maintaining confidence, I think Warren often mentions always "back America", which is why everyone is looking at his latest investment activity after the March sell off and are pondering whether Warren is questioning his "back America' thesis