Monday, May 9, 2011

Warning: Investors Should Stay Away From These Fiscally-Troubled Countries

2011 will hopefully go down as the year the United States finally tackles its imposing budget problems. The arguing has just begun, but by the end of the year, Washington will likely have agreed to some combination of deeper budget cuts and higher taxes. AsI mentioned before, inaction is no longer an option.
Yet in a number of other nations, inaction remains the norm. And because of the rising imbalance between taxing and spending, the International Monetary Fund (IMF) has come out with a forecast of which countries may be in a deep hole by 2015 if they don't act now.
But first you should know that not all countries have similar bearings on your portfolio. Yes, the larger the economy  the greater the chance a train wreck will derail the global economy. But that's not the whole picture. Economic size counts, but it's really about the relative wealth of a country on a per-capita basis. Countries like India and Indonesia may be among the world's 15 largest economies, but their citizens have little extra income to purchase the goods and services that drive international trade. Therefore, economic problems at countries with low per-capita income won't be nearly as devastating as economic setbacks among wealthier nations.
To put things in context, here's a list of the top 20 global economies, according to the CIA's The World Factbook, and where each one is ranked according to per-capita income.

Looked at another way, the following countries score in the top 60, according to both measures:
A major economic crisis in any of these countries would certainly affect a wide range of trading partners. Moreover, these countries have sophisticated banking systems, which have made many loans outside their borders -- so any financial contagion would easily spread.
The clock is ticking…
As noted, the IMF has been focusing on the growing fiscal imbalances currently taking place in many countries. They've looked out over the next five years, and even after accounting for all of the recent belt-tightening measures, IMF economists are still quite alarmed. They've cited 15 major economies that will carry a debt-to-GDP ratio of at least 75% by 2015. The list is led by Japan, which must gear up for a major bout of spending to help rebuild the economy after the recent earthquake and tsunami. Here's the IMF list.
The implications of these runaway budgets are pretty clear.
Let's do the math on when a country carries debt that's the same size as its GDP. A typical government accounts for anywhere from 17% to 23 % of total social spending. This debt-to-GDP ratio means the country will carry $1 trillion in debt by 2015. So in a $1-trillion economy, a government taxes its population at about $170 billion to $230 billion. Yet the interest on existing debt alone would be about $50 billion, or around 20-25% of the budget, if you assume 5% interest rates. As we're seeing in places like Greece, lenders are requiring a higher yield.. An 8% interest rate means $80 billion in interest or closer to one-third of all government spending. That's $80 billion less the government has to spend on other areas such as health, education and defense. For a country like Japan, where debt is projected to be 250% of GDP by 2015, any meaningful spike in interest rates would simply wipe out the country.
To close deficits, governments will need to cut spending and raise taxes much more aggressively, which would add another drag on already-struggling economies. To actually lower those debt-to-GDP ratios, governments need to not only shrink their deficit re out of an economy than it puts in.
This all sounds so scary, and it is. Most of these nations have recognized the disturbing depth of the problem. But none has taken a strong enough action to alter the course. For example, Greece, Ireland and the United Kingdom have all enacted seemingly radical measures to bring down debt levels, yet the IMF still sees debt as a percentage of GDP rising in each of those countries for each the next five years. These countries feel they've done all they can without inciting riots. It's still not enough...
To be sure, the world is also filled with fiscally-responsible governments. Hong Kong, Saudi Arabia, Chile and China all look set to have debt-to-GDP ratios below 10% in 2015. For that matter, Australia, South Korea, Sweden, Colombia and Turkey look to be on relatively healthy footing, even if they have to do some belt-tightening of their own in coming years. But belt-tightening is not necessarily the only action to take. Although tax hikes are anathema in the United States, many of these just-cited countries appear to have struck a balance between too much and too little government. Their tax structures are not overly burdensome, which explains why most are able to post respectable economic growth rates (with the exception of Saudi Arabia, which is propped up by oil).

Action to Take --> 
Unless you're an eternal optimist, you need to seriously reconsider any investments you have in places like Japan and, for that matter, almost all of Europe. These countries' stock markets could represent great buys -- only after their governments have shown meaningful progress on debt reduction. In contrast, more nimble, fiscally-balanced countries, such as Indonesia, Turkey, Columbia and Australia, appear much better-positioned to withstand the coming global financial problems. Luckily, each of these countries has at least one exchange-traded fund (ETF) tracking it. I mention some of my favorite picks in this article, but you should do your own research before committing to one.

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