By Mike Dolan
LONDON (Reuters) - Watch governments' revenues, and not just how much their economies produce, to see if they can support their debt piles.
For investors choosing between bonds of heavily-indebted governments of recessionary European nations and those of the seemingly tidier national accounts in the fast-growing developing world, the point is increasingly poignant.
For over three years at least, the decision was simple.
But after months of shocks to emerging markets and their previously buoyant bond universe in particular, lots of that recently assumed wisdom has come into question.
To be sure, reasons for global market gyrations of recent months range from the jolt to U.S. Federal Reserve policy thinking and the dollar's exchange rate, Chinese growth concerns and domestic political risks in the likes of Turkey or South Africa.
Yet a significant outperformance of bonds of seemingly sclerotic, stagnant western Europe during these ructions raises questions about what investors assume about the relative value of global bonds and how they judge a government's debt sustainability over time.
Credit rating firm Standard & Poor's, for one, stresses the inadequacy of measuring a government's existing debt pile solely relative to national gross domestic product - the basic metric used to assess debt burdens in policy or academic circles.
S&P's sovereign ratings analyst Frank Gill reckons it's at least as important to measure debt relative to a government's income or revenue - much as a bank lending a mortgage will look at your sustainable monthly or annual income as the key basis for judging your ability to service the debt over time.
"What we're saying is debt-to-GDP is not the only ratio to look at it for debt sustainability and there may even be an excessive focus on it," Gill told Reuters. "Governments pay their debts out of tax income, they don't pay it out of GDP."
"Some governments are simply worse than others at taxing and capturing GDP. We're not saying this is a better measure per se, just that you need to look at it if you're going to reach conclusions about debt sustainability."
Gill compiled a list of the highest 10 government debt to GDP ratios last year for the 129 countries S&P monitors and compared that with the top 10 under debt-to-revenue criteria.
While euro zone countries made up half of the 10 countries in the debt-to-GDP list, only two - Ireland and Greece - appear in the top 10 on debt-to-revenue rankings.
Strip out Ireland's bad bank NAMA - which has a separate asset base to fund liabilities - and then only Greece remains.
Italy, Portugal and Belgium - alongside Iceland - drop out of the top 10 when government revenues replace GDP as the key denominator. They are replaced by world's 10th biggest economy India, Egypt and frontier markets Sri Lanka and Pakistan.
"India is one you tend to notice here," said Gill. "Debt-to-GDP is not particularly high by advanced economy standards - about 73 pct of GDP. But once you look in terms of debt-to-revenue ratios, overall sustainability looks much different.
"When average disposable incomes are very low it's just much tougher to increase tax pressure, like introducing indirect taxes, VAT, consumption taxes and so on," Gill added.
Looking at what thresholds start to raise red flags on this measure, the mortgage analogy is useful again as a guide - anything above 3-to-3.5 times income looks like it's a stretch.
And aside from Greece and Ireland, without the NAMA caveat, S&P estimates no other euro zone country will have a debt-to-revenue ratio above 3 for last year or this year.
WILLINGNESS TO PAY?
Though numerous parameters influence creditworthiness - such as the nature of expenditure, overall interest bills, length of average debt maturities and so on - the debt-to-revenue exercise highlights a critical role of government institutions, governance, tax-raising efficiency and social acceptance of tax.
For many investors, this is the main route by which political risk and social unrest makes them rethink bonds.
And it can be quite distinct from party politics, elections or even leadership per se - as seen in Belgium which went without a prime minister or executive government for almost a year between 2010 and 2011 without affecting its debt financing.
BlackRock, the world's biggest asset manager, compiles a quarterly Sovereign Risk Index and uses four key components - 'Fiscal Space' such as debt, deficits and revenues; 'External Finance' around current account balances and foreign currency debt; 'Financial Sector Health'; and 'Willingness to Pay'.
It highlighted significant gains in Italy, Spain, Ireland, Portugal and Greece on the first two components over the past quarter with a headline "EuroPessimism Lifts".
'External Finance' scores, conversely, deteriorated across emerging markets, where 'Willingness to Pay' - defined as effectiveness and stability of government, rule of law and investor-friendly bias - continues to be a big deficit.
The 12 worst scores on 'Willingness to Pay' go to emerging economies - including Brazil, Russia, India and China - and only five of the 25 emerging nations they cover flash positive here.
(Graphic by Vincent Flasseur; Editing by Ruth Pitchford)