This week, Nathan answers the questions we put to him about Bermuda’s fiscal situation and what can be done to improve it.Just how serious is Bermuda’s public debt?A major tipping point in regards to future solvency occurs when the average interest rate on the debt exceeds the countries’ nominal growth rate. When this occurs the debt-to-GDP ratio will automatically increase, and if budgetary constraint is not exercised it will do so at an alarming pace. With an average interest cost of approximately 5.3 percent, a potential nominal growth rate of 3 percent and with a debt to GDP ratio of roughly 25 percent the government at this stage must run a primary budget surplus of about 0.6 percent. In the last ten years this has happened only once. A primary budget surplus of 0.6 percent entails a surplus value of about $33 million. With a current deficit of $166 million the government will need to adjust the budget by about $200 million through expenditure cuts and/or revenue increases. To put this in perspective:— A pure revenue boost assumes revenues soaring by over 20 percent! In other words government would need to produce record revenues when GDP is about nine percent below its peak.— The amount of spending that needs to be cut is equivalent to the size of the entire Department of Health (estimated Health Department spending for 2012 is $191 million).— If the government were to reverse the current payroll concession afforded to the hospitality, retail and restaurant sectors, approximately $49 million in revenue could be raised. It would still, however, need to reduce capital projects and/or general expenditures by some $151 million. To put this figure in perspective, this is double the current budgeted capital projects or the entire budgeted expenditure for the Department of Education.Clearly any government that is serious about dealing with the debt level has some difficult fiscal choices ahead of it. One of the big trade-offs will be maintaining a balance between accelerating economic growth with deficit reduction (austerity) in order to keep the debt in check. While government plays an important role in boosting demand through spending when the private sector is weak, if left unchecked, large volumes of government spending crowds out of private investment. Another way to accelerate growth (without spending money) is to enact reforms to boost growth in the private sector, thereby increasing the tax base and revenues to pay back interest and principal.What fiscal policies do you believe could help Bermuda grow and tackle its escalating debt situation?1. Foster Economic Diversity. Economic concentration continues to be a major risk for the country. Bermuda should try to diversify its current industry focus on insurance and attempt to add economic exposure to other industry sectors such as technology and healthcare that offer greater long-term tail winds for growth. A major stumble or shift in the insurance industry would negatively impact the Bermuda economy and could be viewed as a negative credit event. Efforts should be made to attract disparate industries that have little presence but offer great long-term secular growth opportunities (see my article on attracting STEM company jobs).2 Float a Local Debt Issue. To help reduce the need for external financing and to help retain investment income within the local economy Bermuda should float a debt offering for local institutional and individual investors. Local investors have a vested interest in the country and would be considered stronger hands. Plus the income earned would be locally recycled and paid in Bermuda dollars.3. Foster Increased Immigration and Retention of Expats. Demographics are like an aircraft carrier — its takes a long time to turn. When the course is set it is very difficult and takes a long time to adjust. The only way to counteract this drag is to foster an immigration policy to offset the decline. To simply stem the total potential decline in the labour force over the next ten years, immigration policies should target a roughly 1.4 percent annual net migration ratio — roughly over 500 people per year. This accommodative immigration policy should be focused on promoting new business formation. Without a pro-immigration policy, it is very unlikely that Bermuda will be able to grow economically. To encourage retention a permanent residence programme and/or full citizenship needs to be offered to foster loyalty and a commitment to the country from future immigrants and current ex-past.4. Embracing Creative Destruction and Free Markets. Ironically, a positive aspect of capitalism is failure. The term “creative destruction” was coined by Austrian-born economist Joseph Schumpeter and refers to the process where “bad companies or ideas” fail and free up that unproductive capital for good companies and ideas. Nations where government policy helps to defend weaker industries or companies by artificially assisting them with uncompetitive policies actually holds capital hostage. Without failure, capital and labour cannot be released to find more productive and effective endeavours. They essentially get stranded in a low productivity area which ultimately hampers future economic growth. Policies that encourage competition should be adopted. All policies which restrict foreign investment and companies from entering the market should be relaxed. Policies that protect monopolies or duopolies should also be removed as well as any restrictive labour laws. Specifically the government should go further with its abolishment of the 60/40 law and enhance competition within monopolistic industries. An example of this would be in the liberalisation and deregulation of the telecommunication space to foster a cutting edge and cost effective technology sector.5. Education and Labour Training. The training and advancement of the island’s labour force is critical for future economic productivity enhancement. Governments and corporations should continue to encourage education and continuing professional development to ensure the work force does not fall behind or made irrelevant in today’s globally competitive landscape. A concerted effort should be made to ensure Bermuda’s youth have unfettered access to the best educational standards and vocational training opportunities. Focus should be made in the areas of science, technology, engineering and math.6. “Private Capital and Labour Friendly” Rule of Law. Capital flows to where it is treated best. Today even labour is fungible and lucid. Laws and regulations need to be transparent and “business friendly”. In order to commit sizeable capital investments, foreign investors need to know they are investing in something that is not subject to various forms of appropriation or “rule change”. Government processes and regulation need to be efficient and transparent. In general, less government means more economic growth potential. Empirical evidence and academic studies suggest that private companies are much better at increasing productivity and creating jobs than government. Government should reduce regulation and frictional cost to do business in Bermuda.Given the different portrayals of the fiscal situation from the two parties, voters could be forgiven for asking how serious the debt situation is. What would you tell a voter asking that question?The concept of debt and default risk is very complex and consists of myriad of factors. First of all it is incorrect to simply compare an island economy like Bermuda to large diversified economies like Canada and the US. Small inflexible economies like Bermuda are far more subject to a potential debt crisis because they have limited funding options and levers to avert escalating default chances. For example, history has shown that countries can default even at low levels of debt to GDP ratios. Ecuador defaulted in 2008 with debt to GNP of 20 percent. Albania defaulted in 1990 with a debt to GNP of only 16.6 percent. Russia defaulted in 1991 with a debt to GNP of only 12.5 percent. Thus, even a small level of debt to GNP/GDP is not a factor to dismiss lightly. Reinhardt & Rogoff’s exhaustive study on financial crises suggests that when “external debt levels in emerging markets are above 30-35 percent of GNP, risks of a credit event start to increase significantly.” Currently Bermuda’s debt is trading with an equivalent rating of a about BBB, much lower than its official rating of AA- at Standard & Poor’s. In the highly acclaimed work by Professors Rogoff and Reinhart called “This Time is Different: Eight Centuries of Financial Folly” they state:“Highly indebted governments, banks or corporations can seem to be merrily rolling along for an extended period, when bang! — confidence collapses, lenders disappear, and a crisis hits.”It’s hard to know with certainty what causes this sudden loss of confidence. How can we identify these problems in advance? Michael Pettis has done an excellent job of summarising five aspects that may lead to a crisis. Let’s examine each briefly turn:1. Absolute debt levels do matter. As discussed above, when the average interest rate on the debt exceeds the nominal growth rate of the economy the debt level as a percentage of GDP rises. It’s also worth reviewing the debt level as a percentage of revenues. In Bermuda’s case this is running at a level of 157 percent. One may argue that due to Bermuda’s less diversified economy and lower taxable base, escalating debt levels as a percentage of revenues is worrisome as it would be impossible to adjust policy to capture as much revenue as these more developed nations.2. The composition of the nation’s balance sheet matters. Two major factors affect this: the level of foreign currency debt and the prevalence of short term debt. In Bermuda’s case, debt outstanding is held in US dollars. A problem would arise if Bermuda was unable to maintain the peg it has with the US dollar. If the Bermuda dollar were to depreciate, the US dollar denominated debt would become more onerous and difficult to repay. Luckily, this does not appear to be an issue at this time. The key factor to consider is Bermuda’s current account situation which sits at a surplus. The other aspect is the composition of maturities. A very short maturity spectrum creates a greater risk of refinancing for a country as it may have difficulty rolling over substantial sums suddenly if confidence evaporates. Currently Bermuda’s weighted average debt maturity is about 8.5 years, slightly longer than that of the G10’s 7.3. The economic diversity and level of volatility matters. Typically a country with a very diverse and less volatile economy is viewed as less risky and rates charged on its debt tend to reflect this. Bermuda’s economy is not very diverse and has, over time, become more and more dependent on the international business sector and more specifically, the insurance sector.4. The structure of the investor base matters. Highly levered investors holding Bermuda debt would constitute “weak hands” and could flee at the first sign of trouble. The majority of Bermuda’s debt is held by a group of diverse purchasers. It is impossible to gauge their circumstances. A large piece of debt is held by New York Life (holds $75 million).5. The final aspect to consider is the composition of the investor base. Foreign owners are easier to default on and less likely to remain loyal. In Bermuda’s case, non-residents hold approximately all outstanding debt. Foreign ownership tends to be less patient than more loyal domestic holders.If one attempted to quantify unfunded government entitlement programmes (pension, healthcare etc) which amount to over $1 billion at this stage, it is apparent that funding trends are unsustainable and benefits will need to be reduced and tax payers will be asked to make increased contributions to these programmes over time. At the end of the day, the value of government debt must equal the future stream of discounted government surpluses.If at some point, the market feels the future stream of revenues and surpluses is insufficient to service these growing liabilities it will revolt and force up the interest rates at which the country can borrow. To prevent this from happening, Bermuda still needs a credible plan to bring government spending into balance and a strategy for dealing with ballooning entitlements that are compounding in the face of challenging demographic trends.Ultimately, all these problems are much easier to resolve if government is able to implement policies that stimulate economic growth. Therefore the optimal solution is determining the balance between controlling spending and attracting new business investment.Nathan Kowalski is a chartered financial analyst and the chief investment officer of Anchor Investment Management Ltd.