We live in a world profoundly addicted to debt-financed consumption. Today, many people, companies, and countries borrow with no evident intention to repay. When the debt comes due, they will replace it with new (and often larger) debt. Kick the can down the road, again and again. But inevitably the road ends abruptly with a wall, much like the ones at the end of a crash testing site.

Debt crash test dummies abound—take, for example, the homebuyers during the late U.S. housing bubble or the Iceland banks that borrowed seven times the country’s GDP. These dummies hit their walls a couple of years ago. Soon, many governments—who have thrown money they don’t have, ostensibly borrowing from future generations, into the breach—will approach their walls. Greece recently hit a wall and had to break a lot of promises to its citizens, notably the retirees and prospective retirees from government employment. Greece certainly won’t be the last. The looming sovereign debt crisis will be one of—if not the—defining influences on capital market returns over the next 10 years.

In this issue we explore the relationship between sovereign debt levels and the economic might of the debtor nations. This simple exercise paints a scary picture, particularly for those who rely on cap-weighting their government bond market exposure. Bond investors are lenders. Why should we deliberately choose to lend more to those who are most deeply in debt?

Measuring Sovereign Capacity To Service Debt

Measuring a sovereign’s ability to service debt is not easy. There is no direct measure, so we estimate the capacity to service debt by comparing a sovereign’s outstanding debt to its economic size. We measure a country’s economic size using four metrics that proxy the key factors of production in a capitalist economy. Economics literature typically identifies two or three factors of production: capital, labor, and resources (a subsector of capital). Our fourth factor is energy, the most important subsector of resources, which we treat as a separate factor of production, given its importance. We measure these factors as follows:

Capital: GDP is the most widely used gauge of the size of an economy.

Labor: A nation’s population is the simplest gauge of labor.¹

Resources: A nation’s landmass is a very crude gauge of access to resources.²

Energy: The aggregate energy consumption of a nation is a measure of the energy that goes into production of goods and services. One caveat is that this may be sourced externally through petroleum imports.

Building on our Fundamental Index^® work in equities, we calculate country weights for each metric separately, then equally weight each country’s weight in these metrics to arrive at a Research Affiliates Fundamental Index (RAFI^®) weight. The fundamental measures of size for various economies are presented in Table 1, color-coded to highlight the relative debt burdens with green signifying the financially sound countries and red signifying the debtor nations.

We believe a country’s ability to service its debt is a function of the debt-level-to-economic-size ratio. Thus, we categorize countries into five categories, from light to heavy debt burden, as follows:

Dark Green Fundamental Weight > Cap Weight by more than 100%

Light Green Fundamental Weight > Cap Weight by more than 25%

No Color Fundamental Weight approximately equal to Cap Weight

Light Red Cap Weight > Fundamental Weight by more than 25%

Dark Red Cap Weight > Fundamental Weight by more than 100%

(To see a larger view, click on the image above.)

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