IMF's Growth Forecast Implications for Debt

Yesterday, the International Monetary Fund published its January World Economic Outlook (WEO) Update. The report provides a short update on the September WEO, including IMF economic forecasts. In line with market expectations, growth projections were revised so that they became lower across the board, with the Eurozone countries bearing the harshest adjustments. World Output is now expected to grow 3.3%, compared with the 4% that was previously expected last September. Emerging and developing economies did not escape the frenzy as they too suffered downward revisions to growth; Central and Eastern Europe in particular.

Although most of the press has focussed exclusively on growth, we would like to underline what these new projections mean for debt dynamics of governments - specifically the Government debt to GDP ratio. This ratio is the most widely looked at as an indicator to assess a country’s fiscal sustainability; if projections result in an ever increasing Government debt to GDP ratio, then it is reasonable to assume that downgrades will continue. Therefore, efforts of the IMF and Governments focus on stabilizing this ratio and lowering it if it is ever deemed to plateau at too high a level.

To calculate the change in the Debt to GDP ratio, there is a relatively straightforward formula:

Where:

rt - the average real interest rate at which the government finances itself,
gt - the real GDP growth rate
0t - the primary surplus (government revenues – government expenditures excluding interest payments).
t = time now, t-1 = last year

Let’s take Italy as an example. In 2011, the Debt to GDP (the first term on the right hand side of the equation) is projected to be approximately 121% according to September’s WEO. The real government rate, rt is around 1.5% (4.5% nominal rate – 3% inflation as per September WEO) and 0t is projected to have ended 2011 at around 0.5% surplus. If we assume the GDP growth rate gt = -2.2% (as per the table above), we end up with an increase in the Debt to GDP of 4.07%, therefore moving from 121% to 125.07%. If we took last September’s forecast for Italian GDP growth (gt = 0.3%), the increase in Debt/GDP would only be 0.9%.

Clearly the difference in growth rate has a material and magnifying influence in the Government debt to GDP ratio.

It will be no surprise therefore that the updated Fiscal data forecasts published by the IMF (in a different report – ‘Fiscal Monitor Update’) show a widespread increase in Government debt to GDP ratios, as well as in the Overall Fiscal Deficits (i.e. including interest payments).

The report does not provide specific figures for primary fiscal deficits, so the formula highlighted above would not provide the exact results. As can be seen in the table below, Italy’s Debt to GDP is projected to be a little bit above 125% for 2012.

Although lower growth for 2012 is not new news and is already accounted for in risky assets prices, we think it is important to highlight its effects on sovereign debt dynamics.

Rating agencies have been following this closely. As you can see, France is forecast to be over the 90% Gross Debt to GDP threshold - a level at which the agencies feel that an AAA rating is no longer justifiable. The UK manages to creep in just below that in 2012, but does breach this figure in 2013, so there is very little room left in the AAA rating for slippage.

Hence, it is no surprise that growth was high on the agenda at this week’s meeting of Euro Finance ministers and will be a key topic in Davos.