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Heads over heels


High government debts need to be controlled to prevent a global crisis

Government debt inevitably increases during economic recessions, and especially during economic crises. The COVID-19 pandemic has been no different, except the crisis was severe and widespread, and the increase in government debt on a global basis was the largest ever.

By the end of 2022, global government debt is forecast to be nearly $87 trillion, up from $67 trillion at the end of 2019 just prior to the pandemic. Two-thirds of the increase was in developed market economies, which account for three-fourths of all government debt.

There has been a strong case put forward by some academics and policymakers--especially in developed markets--that rising levels of government debt are of much less concern in an environment of very low interest rates. They have argued that debt sustainability is not at risk if economic growth is higher than interest rates. If this relationship holds, as it has in recent years, government debt as a share of GDP will decline unless there is a large primary fiscal deficit--the fiscal balance excluding interest payments.

This connection between economic growth, interest rates, the primary balance and government debt sustainability is indeed mathematically valid. But as the basis of policy advice is to be less concerned about debt, reliance on these relationships is flawed in three critical areas.

First, economic growth has been higher than interest rates in most countries and in most years over the past two decades, but government debt ratios have continued to rise. Policymakers appeared to take comfort from the fact that as long as the economy was growing quickly relative to interest rates, or was forecast to do so, government debt ratios would stabilize, possibly with tighter fiscal policy in the future if necessary. The problem is the period of debt stabilization has never arrived. Occasional suggestions of "fixing the roof when the sun is shining", or reducing debt ratios when economies were growing, were typically not followed. Global government debt was 62 percent of GDP in 2000, 76 percent in 2010 and is forecast to be 89 percent at the end of 2022.

Second, while much of the policy debate around debt sustainability has been centered on conditions in developed markets, where interest rates have long been low, in emerging markets, where rates have been steadier, the debt also increased sharply. Governments, investors and international institutions seemed broadly content with debt rising in emerging markets despite interest payments rising as well. Emerging markets now experiencing debt distress following the COVID-19 pandemic can trace the roots of their distress to pre-pandemic debt buildups.

The third and most critical point to consider in terms of global government debt sustainability is that the multi-decade decline in developed market interest rates appears to be over now. Market-determined real interest rates are moving steadily higher, and most central banks around the world are confronting higher inflation with higher policy interest rates, though it is longer-term interest rates that matter for government debt. It remains to be seen where long-term rates will settle given the offsetting market concerns with respect to inflation pushing rates higher and a weaker economic growth outlook pushing rates lower. Part of the uncertainty lies in differing views on whether central banks will themselves contribute to lower growth by raising policy rates too aggressively in pursuit of lower inflation. For governments, this point is less critical. The pertinent issue for debt sustainability in the period ahead is not likely to be characterized by strong economic growth accompanied by low and falling interest rates.

As challenging as the outlook is for global public finances, concerns about debt sustainability should not be equated with debt crises being inevitable. An unsustainable government debt burden is one that absorbs an increasing share of fiscal resources, leaving less revenue to be allocated to other spending priorities. This is usually a gradual process, and as such can be addressed over time with policy adjustments.

According to the World Bank, over the next 10 months, as many as a dozen developing economies could prove unable to service their debt. That's a large number, but it would not constitute a systemic global debt crisis.

A debt crisis follows if an unsustainable debt burden is left unaddressed. Creditors then demand higher interest rates, eventually making fiscal financing prohibitively expensive. This can be accelerated by an economic shock, and in emerging markets is often accompanied by currency depreciation, whereby external public debt quickly becomes much more burdensome.

The COVID-19 pandemic has resulted in several emerging markets entering debt crises. Sri Lanka saw the most recent public debt crisis, but it will not be the last. Vulnerabilities to higher funding costs, changes in trade prices, currency fluctuations, geopolitical risks, past policy mistakes and economic downturns will contribute to debt distress and crises.

Developed market sovereign states face many of the same vulnerabilities, and the list of spending priorities for governments worldwide has rarely been longer. Poverty reduction, more equitable economic growth, investments in healthcare, climate risk mitigation, environmental degradation and fairness in technological transformations make for an extended agenda.

Therefore, debt challenges should not be underestimated and steps need to be taken to prepare for them. The eventual restoration of fiscal rules set aside during the pandemic will be important, as will medium-term budget plans that take account of higher interest costs. Many governments are looking to facilitate private sector investment to accelerate certain policy objectives. There will be roles for multilateral funding as well, to better share costs when benefits are also shared, and to provide international assistance where required.

These steps and directional changes are not substitutes for sound public finances, but are instead complementary. Global debt is much higher following the pandemic, but so too are expectations of governments taking on a number of outstanding policy issues. In an environment of rising interest rates, a bigger public policy agenda will require sound public finances and prudent debt management to ensure debt remains sustainable and crises are the exception rather than the rule.

The author is global head of Sovereigns &Supranationals at Fitch Ratings. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.

Contact the editor at editor@chinawatch.cn