Investing in the world's best balance sheets

By Shawn Tully, senior editor at large

FORTUNE -- At the G20 summit in Toronto last month, the leaders of world's largest economies embraced a brave new theme: Halting the alarming, potentially ruinous growth in already mountainous sovereign debt.

Now that the spotlight is shifting to the dangers of big deficits and excessive leverage, many politicians, pundits, and even investors, are mostly ignoring the most remarkable feature of the global debt picture. It's almost exclusively the developed countries that are guilty of excessive borrowing.

Amazingly, the emerging nations, from China to Russia to Brazil to Indonesia, are either virtually debt-free or boast far healthier balance sheets than their giant trading partners. These countries stand as the new models of fiscal prudence.

The developed nations are like the affluent families that borrowed too much on their houses and now struggle to make payments. The emerging market contingent resembles the folks who own their homes free-and-clear, and save plenty on their modest incomes. The future may belong to the nifty thrifty. "The developed world is so over-leveraged that it's passing the baton to the emerging nations," says Rob Arnott, chairman of the California investment firm Research Affiliates, which has developed products that now manage more than $50 billion in assets, including the RAFI family of index funds and ETFs. (See also Rob Arnott's magic indexing formula)

A remarkable new study by Research Affiliates -- comparing debt levels for developed and developing countries -- proves Arnott's point. To gauge if a nation is over or under-leveraged, Arnott contrasts their debt levels with a blend of four factors that assess their ability to pay, based on the size and wealth of their economies. The first is GDP, a yardstick for their supply of capital. The second is total population, a measure of the supply of labor. The third factor is energy consumption, a gauge of how advanced their economies are. The final area is a surprise: The area they occupy in total square miles, which serves as a rough proxy for their holdings of raw materials, a crucial source of wealth.

Arnott calls the average of those four criteria the "RAFI weight." He then compares the RAFI weight with the share of total world debt that the country holds. If that number far exceeds its economic size, as measured by the RAFI weight, then the nation is carrying far too much debt.

Indebted forever

Let's start by looking at developed nations as a whole. The top 24, from the U.S. to Luxembourg, have 41% of the average of GDP, land mass, energy consumption and population among all countries with sovereign debt. But they're burdened with almost 90% of the world's $2 trillion in borrowings.

The forty-six emerging market nations comprise 59% of the world's economy (and 43% of GDP), as rated by the RAFI Weight. Yet they carry just 10.5% of world debt.

Now, let's examine the individual nations. The U.S. looks stretched indeed: By RAFI's measure, it accounts for 14% of the world economy but holds about one-quarter of global debt. But it's a model of probity compared with Japan, which carries 29% of all borrowings, while accounting for only 4% of the blend of GDP, population and other RAFI factors.

Virtually all the nations of Western Europe carry debt that's two to three times their economic size, including the UK, France and Belgium. The surprise is Europe's supposed paragon of prudence, and the economy that the weaklings are now turning to for bailout: Germany. It's burdened with 5.3% of world debt with an economic weight of just 2.6%.

The numbers for the developing world are astoundingly healthy. The two biggest borrowers are China and India, yet their debt loads are exceedingly light compared with the U.S. or Germany. By the RAFI score, China accounts for 15.6% of the RAFI definition of the world economy, but has just 2.3% of the debt. It also holds dollar reserves of around double its debt level, so it could pay off all of its borrowings with plenty left over.

India, measuring 8.6% of the world economy, has less than 2% of total debt. Brazil, Indonesia, Pakistan, Turkey and Argentina all have RAFI Weights of 2% to 6%, but none exceeds 0.2% of global borrowings. The most indebted emerging nation, relative to its size, is Mexico. But compared with most developing countries, its leverage is piddling. Mexico accounts for around 2% of the economy among borrowing nations, and holds less than 0.7% of the debt.

Three reasons to invest in emerging markets

How will the astounding imbalance in debt influence the relative strength of developing and mature countries over the next decade? The emerging markets should perform far better both in growth, and as places to invest, for three reasons.

First, their healthy balance sheets give them far more flexibility to weather another financial crisis than their severely strained trading partners. Indeed, with the exception of China, they're recovering from the turmoil of 2008 and 2009 without the giant increases in government spending that the US and most of Europe resorted to -- spending that further deepened their already deep deficits.

"The emerging nations entered the financial crisis in strong fiscal shape because they substantially reduced debt during past 6 to 7 years," say Uri Dadush, an economist at the Carnegie Endowment. "They've been extremely careful not to sharply increase spending."

Second, their growth rates will be far higher than those of developed nations for a basic reason: They will not have to shoulder the immense interest payments that will require big tax increases, and hence shrink the size of the private sector, the main engine of growth. The higher growth rates should make emerging market equities far more attractive than those of the US, Japan, or Germany going forward.

Emerging markets far surpassed the returns in the developed world in the last ten years, yielding around 10% total returns vs. zero for mature economies. Look for a continued period of big outperformance in stocks.

Third, emerging market bonds will also outpace fixed income in the developed markets. "The reason is that their yields are far better than those on treasuries, yet the risks of investing in emerging market bonds are highly exaggerated," says Arnott.

That spread today is around 2 to 3 points; Arnott reckons that the bonds for most emerging market nations should boast yields that are about equal to treasuries. So investors can expect nice capital gains as those spreads narrow in the future.

The balance of power is shifting, and most developed nations are ignoring that historic trend as they spend and borrow recklessly. It's time for them to show the same prudence, and learn the same lessons, that now guide their emerging market partners.  To top of page

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