Record High Debt and Record Low Rates

Oct 13, 2012


- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
Imagine you are a lender. You are evaluating the creditworthiness of two potential borrowers. The first borrower has very high debt levels that exceed his annual income, and needs to borrow just to stay afloat. The second borrower hardly has any debt at all. Naturally, the first borrower is a higher risk than the second one. So it would make sense as a lender to charge the first borrower a higher interest rate as compared with the second borrower, in order to compensate for the increased risk.

Now let's translate this example into the global debt crisis. Countries with high debt levels should see rising borrowing costs, to compensate for the fact that they have a greater risk of default. And this is the case for the European countries going through debt crisis. Greece, Spain, Ireland, etc. have all seen their borrowing costs rise, as evidenced by the rising government bond yields.

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But somehow this logic fails when we apply it to certain countries. The US has a debt to GDP ratio in excess of 100%, yet its 10-year bond yield is less than 2%. Japan has a debt to GDP ratio over 200%, yet its bond yield is less than 1%. The UK has a bond yield less than 2% despite a debt to GDP ratio near 90%.

This is a case of record high debt levels and record low interest rates. Something funny is going one here. Why is it that these countries have debt levels that are at similar levels as compared with European countries going through problems, yet they can borrow so much cheaper?

The main difference between these two groups of countries is the currency of their debt. The US, Japan, and the UK all have their debt denominated in their own currency, for which they can adjust interest rates and increase money supply. The peripheral Eurozone countries have debt denominated in the euro, for which they have no direct control over the interest rate or money supply.

Thus, what matters is the currency of the debt. Going back to the example in the beginning, if the high debt borrower also has the ability to reduce the value of his debt, he is no longer as risky as before. In the Indian case, our debt to GDP ratio is near 70%. Our government bond yield is 8%, which in real terms is around 1% (i.e. inflation at 7%). Again, debt in a currency we can control is not perceived as risky.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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1 Responses to "Record High Debt and Record Low Rates"

Krishnamurthy

Oct 14, 2012

Asad's idea seems very illogical. For India US, UK,Japan and European countries he uses a yard stick different from what he is using for India. If we adjust the interest rated based on current infaction rates, the results establish that he has got the relationship between debt and interest rates all wrong when applied to nation states.

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