For most of the first decade of the 21st century, world public finances were in a Goldilocks zone. Budget deficits were minor, public debt was under control, and rapid economic growth amid the internet revolution and soaring commodity prices offset high nominal interest rates.
A little over ten years—and two global crises—later, and public debt-to-GDP ratios in many countries are now at multi-decade highs. A record seven emerging markets defaulted on their debt obligations last year, with more likely to follow in 2021. Developments in advanced economies are also unnerving some: In the U.S., the Republicans have warned of the impact of Joe Biden’s stimulus spending on the public purse, while the German opposition in parliament has also sounded the alarm over the rise in debt in a country traditionally famed for fiscal prudence.
But with the political and economic scars still fresh from austerity in the wake of the Great Recession, few governments appear in a hurry to withdraw current fiscal largesse. Their stance is facilitated by today’s low yields, which make interest payments less burdensome than in the past. What is more, in an age of strained public services and rising inequality, higher debt-financed government spending is seen by many as not just tolerable, but advisable. Against this backdrop, our panelists see no progress on reducing global public debt levels over our forecast horizon. All of this begs the question: Should we be alarmed?
- Beyond the debt ratio
There are historical precedents for current debt levels—albeit generally linked to periods of conflict. The UK’s public debt-to-GDP ratio was close to 200% in the aftermath of the Napoleonic wars in the early 19th century, while the ratio among advanced economies rose to well over 100% as a result of WW2.
In both cases, subsequent economic performance was impressive: The UK was the preeminent world power for the remainder of the 1800s, while the decades following the end of WW2 became known as the Golden Age of Capitalism thanks to sustained improvements in living standards, full employment and declining inequality.
At the same time, public debt declined sharply from its peak. In the case of the UK, the ratio fell to around 40% by the dawn of the 20th century, on the back of prudent government spending and the introduction of the country’s first income tax. The decline in debt across economies after WW2 was driven by booming activity, moderately high inflation, and “financial repression” under the heavily regulated Bretton Woods system, which pushed down nominal interest rates by placing restrictions on savings.
As such, the absolute level of public debt is likely a poor guide to debt sustainability: Rather, a country’s ability to pay back its debt is the key. In this sense, the debt position of most developed markets still looks tenable: The portion of government revenue assigned to servicing debt has actually tended to fall in recent years as interest rates have declined. Developed economies also have deep domestic capital markets and debt denominated in their own currencies, limiting the risk of default. And central banks would step in to tame any sharp increase in yields, keeping borrowing costs affordable.
Pockets of risk do exist however—chiefly in Europe. “The high level of [Greek] government debt means that the risk of another restructuring remains,” states Maddalena Martini, economist at Oxford Economics. “[…] The necessary fiscal response to the coronavirus crisis has pushed Greece into a large fiscal deficit in 2020–21, which is concerning.”
Analysts at the EIU have a similar take: “Many of the European countries that are among the worst affected by the epidemic, such as Italy and Spain, already had weak fiscal positions before the coronavirus outbreak. South European states are still recovering from years of austerity, combined with high levels of public debt, ageing populations and persistent fiscal deficits. […] A debt crisis in any of these countries would create massive turbulence on financial markets.”
- An emerging crisis
The situation in emerging economies is far more precarious: Despite having much lower public debt-to-GDP ratios than developed markets, debt servicing costs eat up a far larger portion of government spending. In the EU, debt interest payments were worth less than 5% of government revenue in 2019. For Brazil and India they were over 20%—a figure which likely rose substantially in 2020 as the pandemic hit tax revenues and forced countries to lean heavily on debt markets. And with many national treasuries stretched to the limit, the last year has seen a cascade of credit rating downgrades, further increasing bond yields in a vicious feedback loop.
“Higher debt service costs [in emerging markets] are […] expected to constrain their ability to address social needs, including rising poverty and growing inequality, or to correct the setback in human capital accumulation during the crisis,” said the IMF in a recent report.
Emerging markets also tend to have a high proportion of debt denominated in foreign currencies, making them vulnerable to shifts in investor sentiment. Many analysts fear a repeat of the 2013 “Taper Tantrum”, when the Fed’s decision to wind down its stimulus program led U.S. bond yields to spike and put acute pressure on many emerging-market currencies, forcing governments to jack up domestic interest rates.
Combine these factors with the limited access to vaccines in many parts of the developing world, which could cause the Covid-19 pandemic to rumble on far after wealthy nations have returned to normality, and all the ingredients for a debt crisis are present.
“Unless we take decisive action on debt and liquidity challenges, we risk another ‘lost decade’ for many developing countries, putting the achievement of the Sustainable Development Goals by the 2030 deadline definitively out of reach,” warned UN Secretary General António Guterres recently.
That said, there are some reasons to believe things could be different this time around. Central banks in emerging markets have taken a more active stance over the last year: Many now have quantitative easing programs in place to quell upsurges in yields. Economies generally have sounder balance-of-payments positions today compared to 2013—partly owing to depressed domestic demand due to the pandemic. And the current rise in yields has been driven by optimism over the economic outlook, which could keep capital flowing to emerging markets.
“Higher U.S. interest rates would likely be manageable for most emerging market economies if they are orderly and reflect stronger growth expectations, as in such a scenario, risk premiums on bonds tend to fall,” said Trieu Pham, emerging markets sovereign debt strategist at ING. “Nonetheless, those with high fiscal and external vulnerabilities would remain at risk.”
The rich world has also provided support. The IMF has made around USD 250 billion available to member countries, and could soon see its firepower boosted by a further USD 650 billion. The G20 recently extended its debt relief scheme until the end of 2021, and in November 2020 established a “common framework” for how poorer nations could approach debt restructuring.
But these measures have drawbacks. Crucially, they generally delay the pain for emerging markets rather than reduce the total stock of outstanding debt. The presence of private creditors in the common framework is voluntary. And countries could be reluctant to participate due to a fear of being locked out of international capital markets—Ethiopia was swiftly downgraded by two of the three major rating agencies after announcing its intention to make use of the scheme in late January.
“The key concern for eligible countries is whether the Common Framework will restrict access to borrowing in commercial markets or raise debt servicing costs, given the risk of credit rating downgrades and/or deterioration in market reputation as a result of seeking to reschedule private-sector liabilities,” commented Chris Suckling, analyst at IHS Markit. “The concerns have been exacerbated by a lack of co-ordination between the Paris Club, private creditors, and ratings agencies […], which contributed to a perception that agreement to the deferral of official bilateral credits necessarily implied the subsequent eventual deferral of private credits.”
Economists at the EIU hold a sober view on the outlook: “Debt repayments will remain outstanding and continue to accrue interest as time passes. Many countries will therefore emerge from the current virus-driven economic crisis even more indebted and financially stressed than before. This will raise concerns about their ability to repay external debt in the absence of more comprehensive debt-relief plans. Sovereign defaults […] are likely among poor countries in the medium-term.”
- The way forward
Defaults are certainly the quickest route out of a debt crisis, and likely the most politically palatable, but they are no free lunch. After failing to make debt payments in 1982, Mexico found itself cut off from capital markets for most of the decade, while Argentina was unable to borrow internationally for 15 years following default in 2001. A lack of financing from abroad limits domestic investment and ties the hands of governments in the event of a downturn.
The costs of alternatives may be even higher: Fiscal austerity would depress demand and may tear already-stretched social fabrics, while any attempts to simply inflate away debt would hurt consumers’ purchasing power and risk spurring a wage-price spiral.
In the longer run, growing out of debt by boosting emerging economies’ productive capacities could be a key strategy—and would also have the happy side-effect of improving living standards in the process. However, this would necessitate undertaking reforms today with no short-term political payoff.
Meanwhile, developed economies are at little imminent risk of default, but would be wise to avoid complacency. If monetary authorities are forced to reduce their market activity in the face of intensifying price pressures, this could see artificially-depressed bond yields spike and debt interest payments gobble up a higher share of public spending. And even though as a last resort, governments could always instruct central banks to print money to meet overly onerous domestic-currency debt obligations, this risks runaway inflation.
Concern then—but not alarm—seems the appropriate reaction to the huge accumulation of developed-market public debt over the last decade. In emerging markets, the alarm bells have already been ringing loudly for some time.