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Risks to Government Debt Sustainability

by internationalbanker

By James McCormack, Managing Director and Global Head, Sovereigns & Supranationals, Fitch Ratings

 

 

 

The events of the previous three years put extraordinary pressure on global public finances, with the COVID pandemic, wars and energy shocks contributing to recessions, inflation, higher government spending and lower government revenues. The upshot has been increased government debt to record highs in nominal terms and relative to gross domestic product (GDP) for many countries. Some of the fiscal stresses of the last few years will relent, but outlooks for economic growth and interest rates will add to debt challenges, and the long lists of critical public spending and investment priorities will need to be managed in that context.

There are numerous ways to illustrate the global fiscal transition since 2019. Fitch Ratings has forecasted the median global deficit to be about 3 percent of GDP in 2024, compared with 1.6 percent in 2019, and the median government debt ratio to be about six percentage points (ppts) of GDP higher, at 54 percent. Perhaps the most telling change is in governments’ interest-service burdens. In sum, governments will pay about US$2.5 trillion in interest in 2024, up by nearly $1 trillion since 2020. All else equal, higher interest payments mean diminished fiscal flexibility as governments become more constrained in their spending decisions. Alternatively, they must generate more revenue or—in the worst case—borrow to pay interest.

Interest payments are typically measured as a share of GDP or government revenue, reflecting both changes in debt stocks and prevailing interest rates. As a rule, interest service ratios (ISRs) are higher for emerging-market (EM) governments than developed-market (DM) governments, reflecting the higher risk premiums attached to EM borrowers, underdeveloped EM capital markets and the pre-COVID multi-decade decline in DM interest rates that was not mirrored in EMs.

In 2024, for example, median interest-to-revenue ratios for Sub-Saharan African and eurozone governments are forecast to be 14.5 percent and 2.9 percent, respectively. In both cases and for other regions between these two extremes, interest-to-revenue ratios are trending higher, and they will continue to do so based on adjustments that have already taken place in debt stocks and interest rates.

Recent US data confirms just how quickly interest costs can jump. On a 12-month trailing basis, the federal government’s net interest payments reached $730 billion in December 2023, up from $518 billion a year earlier and $367 billion at the end of 2021. Despite the sharp increase in interest payments, they still do not fully reflect the rises in interest rates, as that will happen only as debt issued at lower rates matures and is refinanced. If the average interest rate on US government debt moved instantly to 4 percent, interest payments would exceed $1.3 trillion annually.

What lies ahead?

As challenging as recent years have been, there are three reasons why the fiscal path ahead is likely to be equally difficult.

First, interest rates in DM economies are likely to be permanently higher than they were pre-COVID. The period between the Global Financial Crisis (GFC) and COVID was one of exceptionally low policy rates, as inflation remained at or below central banks’ targets. Low policy rates were supplemented by quantitative easing (QE), pushing bond yields lower. The 10-year US Treasury yield—arguably the most important benchmark for government borrowing worldwide—was well below its long-term average, including on an inflation-adjusted basis.

Since the return of inflation in 2021, there has been a tightening of global monetary policy that will not be fully unwound. Inflation is now in decline, but it is not yet clear where it will settle. More importantly, central banks in DMs will be cautious in bringing rates down, as several have openly acknowledged their misreadings of inflation dynamics two years ago when they were slow to respond to what they misinterpreted as a transitory upswing in prices. Maintaining policy credibility points to a greater degree of inflation diligence going forward.

Structural changes in the interest-rate environment will require rethinking widely subscribed pre-COVID arguments that governments could and should borrow to invest on the premise that economic growth spurred by such investments would run consistently ahead of interest rates on the debt, contributing to more easily manageable debt-to-GDP ratios. Unfortunately, debts incurred based on such arguments still exist and face higher interest rates with bigger fiscal implications when refinanced.

The second factor that will contribute to the fiscal stress ahead is the growing list of government spending and investment priorities. Reducing social and income inequalities was identified as an important objective in the years immediately preceding COVID, although tax and spending policies were not meaningfully adjusted, and COVID’s urgency partly overtook those issues.

The most obvious public investment and spending priorities that COVID has not overtaken are climate-mitigation efforts and facilitations of energy transitions away from fossil fuels. According to the International Monetary Fund (IMF),1 getting to net-zero emissions by 2050 could add as much as 45 to 50 percentage points of GDP to government debt ratios in some countries, depending on the specific policy mix, with the estimates subject to considerable uncertainty.

While the costs to governments are uncertain, their central roles in confronting climate change are not. Climate issues will not recede as a policy priority as income inequality appears to have done (at least for now), and governments will be unable to step back from climate, as some central banks have to renew their focus on core responsibilities related to inflation and financial stability. It is hard to imagine government responsibilities that are more “core” than dealing with existential risks.

The third factor that will challenge fiscal positions in the years ahead is the escalation of geopolitical risks. In response to the war in Ukraine, for example, NATO (North Atlantic Treaty Organization) members agreed last year to spend 2 percent of their GDPs on defense; most member countries had not met this long-standing pledge previously. And tensions between China and the United States have led not only to restrictions on cross-border trade and capital flows but also to the return of active industrial policies that extend well beyond the two protagonists. Taxes and subsidies are being tweaked to encourage domestic production of goods previously imported. Greater economic autonomy boosts national security, but there are associated costs, and they will be borne in the first instance by governments.

The past as a guide to the future

Higher interest rates added to elevated debt levels, pressing spending and investment agendas and the costs associated with rising geopolitical risks make for a potent fiscal mix. A plausible path for the years ahead is that many governments will remain heavily indebted, with policymakers doing enough to broadly stabilise their debt-to-GDP ratios when macroeconomic conditions are favourable. Of course, macroeconomic conditions never remain favourable, so debt ratios will be prone to rise when recessions take hold or crises emerge, suggesting a pattern of debt ratios ratcheting higher over time.

This is not a predetermined path, however, as there is an established history of DM governments (EM historical data are less readily available) bringing down their debt ratios. The means by which they have done so is critical and relates to the aforementioned pre-COVID view that it is sufficient for interest rates to be exceeded by GDP growth rates to ensure debt sustainability. But, in fact, these conditions have proven not to be sufficient. Since the 1970s, governments have run primary surpluses equivalent to more than 2 percent of GDP in nearly all cases in which DM government debt-to-GDP ratios declined over multi-year periods.

Now that interest rates have risen from their lows, managing government debt ratios will be more difficult, especially since most countries are running primary deficits. Big fiscal adjustments driven by debt-reduction objectives (i.e., austerity policies) have largely been discredited, with the effects on economic growth and the provision of public services considered too high a price to pay. A surge in economic growth that would allow countries to grow out of their debt problems also seems improbable, especially in DM countries.

So, where to go from here? Policy advocates in DMs rightly emphasise the need for governments to take leading roles in confronting inequalities, addressing climate change, facilitating energy transitions and responding to geopolitical uncertainties. Missing are equally robust discussions of governments’ funding options and debt challenges. To move the various agendas forward, more public debate on allocating government spending, not just calls for more spending, is needed. There is little, if any, debate on the imposition of higher taxes.

The risks of not explicitly acknowledging the financial constraints of governments in the short term are that debt levels will continue to rise and concerns around debt sustainability will reach an eventual tipping point in the medium term, perhaps driven by market pressures affecting funding costs. This would force a more arduous fiscal adjustment, with policymakers under some duress. The time for setting policies in place to avoid such an outcome is now.

 

Reference

1 International Monetary Fund (IMF): “Climate Crossroads: Fiscal Policies in a Warming World,” October 2023.

 

 

ABOUT THE AUTHOR
James McCormack is Managing Director and Global Head of Fitch Ratings’s Sovereigns & Supranationals Group. James re-joined Fitch in 2013 from the Bank of Canada, where he held a senior credit role. Prior to this, James was with Goldman Sachs as an Executive Director in credit-risk management and advisory and with Fitch as Head of Asia Sovereigns.

 

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