The credit of the United States of America has been downgraded by one of the rating agencies and the decision has sparked a debate as to the meaning of a downgrade. The move also put into question the method by which the agencies determine the risk of a country. In my view, the trouble with the method now used is that the GDP of the country is taken into account. What happens here is that a ratio between the GDP and the level of the country's overall debt is established; and this singular figure is allowed to loom large in the final analysis. But I believe that while the method can sometimes be trusted to accurately reflect the risk of a country with respect to the debt that is incurred internally, it can never reflect the risk with respect to the debt that is incurred externally. In other words, it is one thing to consider the ratio between what you produce as a country and what you borrow from the local citizenry; it is another thing to consider the ratio between what you produce internally and what you borrow from external sources.
To see why I make this distinction you need to look at the following example. You are a citizen of country A and you have 100 dollars to invest. Say, you have a birthday coming up, and instead of using the money to buy a few goods and services, you decide to invest the money for one year and spend it on yourself next year. You do the research and discover that you can lend the money to your own government by purchasing a one year bond that yields a 5% interest. This means you will be buying the promise that 105 dollars will be returned to you at maturity. Assuming for the moment that inflation will be negligible in the coming year, you envision cashing the bond by your next birthday, buying all the things you could have bought this year and still have 5 dollars left in your pocket.
Let us now suppose that while you live and work in country A, you learn that country B offers a one year bond that yields a 7% interest. This means that if all else is equal, you will have the opportunity to go through the same scenario and have 7 dollars left in your pocket come next year -- a better deal on the surface than the 5 dollars offered by your country. But because you take nothing at face value, you ask yourself which offer you should pick and, in trying to answer the question, you decide to turn to the rating agencies to see how much risk they say exists in either country defaulting on its obligation. And before you do this, you sit down and quietly reflect on the subject for a moment.
The first thing that comes to your mind is that a country in difficulty will do its utmost to avoid defaulting on its obligation. A government that finds itself in a situation like this will ask the citizenry to do the proverbial tightening of the belt. This means that the people will be asked to consume less and possibly pay more in taxes to use what is saved to pay off the creditors. But realizing that the creditors are of two types -- the local and the foreign -- you begin to see that you cannot make one determination to fit both situations. That is, you reason that while it makes sense to take into account the value of all the goods and services (GDP) produced locally and compare that to the debt owed to local creditors, it does not make sense to consider the part of the GDP that cannot be exported and compare that with the debt that is owed to external creditors.
And the reason for this is easy to parse. It is that when you buy the bond of a foreign country, the expectation is that the capital and the interest will be returned to you not in the form of tangible goods or in services that you can use but will be returned in the form of the country's currency. Yes, it happens at times that a country will issue a bond denominated in the currency of another country but this happens only on rare occasions and only when it has already been determined that the country issuing the bond is a risky one indeed. Most of the time, however, a country that issues a bond in its own currency will have a GDP that shines on paper where the shine may hide difficulties buried deep behind the numbers. And what must concern you as an investor planning to invest in a foreign country is the thought that if more of the country's currency will find itself on the world markets than the country has goods to export, the value of the currency will diminish on those markets. And if you hold some of this currency or if you have an investment instrument that is based on it, you will lose more than can be offset by a higher yield. For example, if you get an extra 2% in yield and you lose more than that because of the shrinking value of the currency, you will have made a bad investment.
And this will stand in contrast to investing in the country where you live and work even if you invest in instruments that offer a lower yield because you will have here an advantage that will offset the low yield. You reach this conclusion because you reason that if your country gets into difficulty and if the people are asked to tighten their belts, they will consume less of the goods that can be exported but will continue to consume the same amount of services simply because most of the services are not exportable. This means that while the supply of the goods will diminish and thus cause an upward pressure on their prices, the supply of the services will remain constant and thus keep their prices steady. Therefore, if you invest in the country where you live and if the country gets into difficulty, you will feel the effect of the difficulty only partially. That is, you will pay more for the goods you buy but not for the services. And when you consider that the expenses on material goods represent less than half the total expenses made by an average household, you conclude that it will be less risky to invest in country A with a 5% yield than country B with a 7% yield.
And you will now see why it is absurd to use the ratio between the GDP of a country and the level of its external debt as a means to determine its credit worthiness. It is that the GDP contains the value of all the goods and services produced in a country when only the exportable goods should be considered because only they can be used to redeem the external debt. The logical thing for you and for the rating agencies to do, therefore, is to assign two credit levels to each country; one for the investors who live inside the country and one for those who live outside of it. For example, a country can be AAA for those who live and work inside it but can only be AA+ for those who live and work outside of it. However, it must be said that if the currency of a country is used as a reserve currency by the rest of the world, the whole world should be considered as local domain. This is where America stands today and where it shall remain until something substantial changes.
And what all this means is that we have two competing ideas to wrestle with. On the one hand there is the decrease in the value of the currency on the world markets, a phenomenon called devaluation; on the other hand there is the decrease in the value of the currency at home, a phenomenon called inflation. And so we ask which of the two phenomena should concern us the most when making practical decisions. The answer is that it all depends on who you are and what relationship you maintain with the world. If you are an ordinary citizen who is only concerned about your birthday, your concern will be limited to the imported items that you intend to buy, if any. It is that the possible devaluation of the currency will increase the price of these items and so you will do well to buy them this year. But if you are a business person who regularly buys machines and/or raw material from foreign sources and if you sell your finished products abroad, the devaluation of your currency will affect you in a more complicated way. You will pay more to buy the machines and the resources but you will have the opportunity to sell more of your finished goods abroad.
Bear in mind that when it comes to inflation at home, most governments have the necessary tools to control it, something they do successfully most of the time. However, matters can get out of hand and a hyperinflation can set in. This means that a situation may develop where it will cost hundreds, even thousands of times more to buy the goods and the services that you used to buy at a reasonable price. If and when this happens, and if it goes too far, the currency of the country is usually junked and a new currency created by erasing a few zeros off the junked currency. In these cases, to be caught with a debt instrument such as a bond will prove to be a bad investment while equity will prove to be a good one, especially if it is directly or indirectly related to a commodity.
And this leads to the question: What should the credit agencies consider when assessing the risk of a country? Well, it must be clear by now that the main concern of the agencies should be the ratio between the foreign debt of the country and its ability to export material goods like the natural resources it has in the ground and the manufactured goods that it produces. The resources can be renewable such as agriculture which is the best gift that a country can have; or they can be non-renewable such as the metals and the minerals. In the case of the latter, the size of the reserves more than the daily production ought to be taken into account because this is what determines how long the bounty will last. And related to this question is the effort made by a developing country rich in resources to diversify its economy as a way to prepare for the day when the resources will be depleted. And because a depleting resource is a serious matter, it must be taken into account when establishing the long term credit worthiness of these countries. In fact, the rating of their debt should be based on where their economies are projected to be when the debt will come due. If it is seen that the country will have depleted its resources and still have no manufacturing base to replace it, the debt will have to be rated as risky.
However, it can happen at times that the exception to the rule would play a big role in the fortune of a country. For example, the small island nations situated in the Caribbean enjoy a combination of circumstances that allows them to maintain a high standard of living without being blessed with reserves of natural resources and without having a serious manufacturing base. What they have instead is a magnificent climate that is maintained all year long. Situated close to America which is a large and wealthy nation populated by people who go on vacation on a regular basis, the islands of the Caribbean are blessed with a small population where the needs of everyone can be met with the income earned from tourism and from the selling of the related services. Should one of these countries need to issue a bond to finance a project related to tourism or otherwise, the bond will have to be rated as safe.
When it comes to most other countries, however, it is preferable to have a large population. In fact, the size of the population and its demographic composition should be taken into account when assessing the credit worthiness of these countries. For example, in India, in Egypt and in many emerging nations where there is a large and young population, the youngsters of today will be the ones called upon to pay off the debts that their elders are incurring. These are debts that the elders take not to live high on the hog but to build the infrastructure that the youngsters will rely on to develop the world of tomorrow. What this means in practical terms is that the more youngsters there are in a country, the less each of them will be asked to contribute to pay off the debt. Thus, for 80 million Egyptians to be saddled with a foreign debt that is in the neighborhood of 32 billion dollars is such a small matter it should not worry the credit agencies. The same goes for India whose population is 1.2 billion people saddled with a debt that stands in the neighborhood of 240 billion dollars. You can see how insignificant these figures are when you contrast them with the 7 million Israelis who are saddled with nearly 100 billion dollars in foreign debt.
What you see here is that while every Israeli owes the foreign creditors more than 14,000 dollars, every Indian owes 200 dollars and every Egyptian owes 400 dollars. And this is not the whole story because the populations of the emerging countries continue to increase as the countries continue to industrialize. In the meantime, most of the countries that view themselves as industrialized (which is not always true) are being hollowed out of the little industries they have left. First, they depleted their own natural resources or they never had them; and now they are neglecting their manufacturing base or they never had it in the first place.
You can see this reality and appreciate its significance when you examine another set of numbers related to two countries, Israel and Egypt. You see that there are approximately 300,000 Israelis (including 65,000 farmers) producing material goods that can be exported to pay for the external debt. This means that each of them will have to contribute 330,000 dollars towards that goal. Can they make it and still produce enough food and manufactured goods to satisfy the local population? You judge. By contrast, there are 11 million Egyptians (including 8 million farmers) producing material goods. This means that each of them will have to contribute 2,910 dollars to pay for the external debt. Can they make it and still produce enough food and manufactured goods to satisfy the local population? You bet they can.
At this point we must not fall in the trap of looking at the frozen picture of an existing situation and believe that it will not change. In fact, the realities on the ground will continue to evolve but since nobody can predict the future, we can only make projections as to what the picture will look like as time moves on. What we can say with some confidence is that the population of Egypt will continue to increase till it reaches 120 million people where it will begin to stabilize. In the meantime, people will continue to migrate from the countryside to the urban centers. Eventually, the labor force of the country will reach the 50 million mark of which 8 to 10 million will be in the non-farm goods producing industries while farming will become highly mechanized. All of this will mean that Egypt can now borrow as much as half a trillion dollars to invest in its industries and not worry about being able to pay back the debt.
As for Israel, the future is so bleak it is hopeless for this sad place. The country has no natural resources to speak of, a small farming industry that already cannot feed the local population and a manufacturing base that depends largely on jewelery and the polishing of diamonds. The Israelis also have a small chemical industry and a building material one as well as what they call a high tech industry that is more software than hardware. This is an industry where grownups make applications of the sort that kids make in North America when they seek to earn a few dollars to get away from having to flip hamburgers. On the other side of the ledger, Israel is already indebted to the tune of 150 billion dollars, two thirds of which is co-signed by America and owed to foreigners while the remaining third of the debt is owed to Jews of dual citizenship. These are people who say they live in Israel because they maintain a cottage there which they occupy when they travel to Israel or they have a post office box to which you can write when communicating with them on Israeli matters.
When the financial crisis hit the world in 2008, it became evident that America will no longer be able to carry the Israeli parasite on its back. The business people and the lenders began to pull their money out of Israel, and the central bank there was forced to raise the interest rate in the middle of the economic downturn to encourage the money to stay. Even then, the bank could not find enough money to redeem the bonds that were maturing but instead of telling the truth and thus raise the specter of a default, Israel and America fabricated a lie to the effect that America was going to finance the deployment of some idiotic system of defense in Israel that everyone knew was a bad joke. Still, America gave Israel a check in the amount of 205 million dollars which the latter used to redeem the debt that was coming due and to buy some food. This money has now been used up at a time when new debt is coming due and when the country is running out of food again. And everyone in the world can see that something big is about to happen with regard to 150 billion dollars that America may ultimately be asked to dish out in the name of the Jewish parasite it is carrying on its back.
It ain't gonna be pretty and it ain't gonna smell nice. Wake up rating agencies, a train full of kosher manure is about to get wrecked and you will be smelling more than the coffee.