Global Sovereign Debt: Are We Heading Towards a Debt Crisis?

Chennai: By 2029, global public debt is projected to climb to around 100% of global GDP. While advanced economies like Japan and the US already have debt exceeding their GDP, a debt crisis is looming large over the global economy with central banks finding it difficult to tame inflation and steer growth. The higher bond yields in advanced economies will put pressure on emerging economies, including India, and trigger capital outflows and pressure on currencies. This will lead to curtailment of social welfare spending, climate-related expenditure and higher taxes, finds Annie Mahajan, Senior Economist at CareEdge Global Ratings.

Global sovereign debt is at record-high levels. Tell me more about this and which countries currently have the most risky debt levels.

Sovereign debt levels have risen to all-time highs. Global debt surged to nearly 97% of GDP during the pandemic because of the large fiscal stimulus, social spending and government subsidies that most countries provided.

There was a brief period of correction, but that was followed by global monetary tightening. Borrowing costs subsequently increased, and global debt levels began rising again. The situation now looks particularly concerning, with global debt expected to reach nearly 100% of GDP.

Advanced economies account for a major portion of this increase, with the US being one of the biggest contributors. Other economies with already high debt levels include France and Japan, whose debt is close to 250% of GDP. Among emerging economies, China has been a major contributor to the increase as it has continued scaling up its debt levels.

We saw debt levels rise during the pandemic and also during the global financial crisis. Why are countries borrowing more now, and how will refinancing further add to this debt burden?

During the global financial crisis, we also saw a surge in global debt. But one comforting factor at that time was the cost of borrowing. Borrowing costs were particularly low for these economies, so debt affordability was not such a major concern.

Now the situation is reversing. For advanced economies, long-term bond yields have surged to very high levels, with US yields averaging close to 5%, while other advanced economies have followed the same pattern. Japan, which had not experienced such a surge in yields for a long time, is also facing this change.

One of the biggest reasons is that markets are increasingly apprehensive about the fiscal risks facing these economies. Both structural and cyclical factors are responsible.

Advanced economies are ageing rapidly. A significant proportion of their populations is expected to become super-aged, which means higher healthcare costs and greater social spending. As a result, deficits may not narrow because these expenditures will continue to consume a significant portion of government spending.

Why are these countries finding it so difficult to bring in reforms and reduce their debt levels?

Countries such as France and Germany are increasingly facing social and political resistance to pension reforms. There is strong public resistance to any curtailment of government spending.

The US faces a somewhat different problem, with periodic uncertainty and repeated debt-ceiling revisions. Such uncertainty can dilute public confidence in institutional structures.

Spain, meanwhile, has not been able to pass a budget for the last three years and has continued with the same budget. These political and institutional constraints make it more difficult for governments to execute reforms and reduce deficits.

Apart from the pandemic, what are the factors currently driving debt levels higher?

There are several factors. Apart from the Russia-Ukraine war and other geopolitical conflicts, we have also seen geopolitical fragmentation and repeated trade disruptions caused by tariffs and protectionist policies.

These developments could hamper medium-term growth prospects for many economies. At the same time, the West Asia crisis has brought inflation back as a significant challenge. With inflation risks re-emerging, central banks are no longer in a position to keep interest rates low.

Higher interest rates translate into higher bond yields and higher borrowing costs. Ideally, interest rates should be lower than the growth rate, or growth should be strong enough to compensate for primary deficits so that debt ratios can come down.

But right now, yields are rising, growth is expected to slow and deficits are expected to widen. That combination means debt levels are likely to increase further.

How significant is the refinancing risk?

A number of countries, including the US, Germany and Japan, have increasingly relied on short-term financing to fund their debt. Short-term debt comes with a refinancing cost, and that means refinancing risks increase as borrowing costs rise.

During the global financial crisis, central banks had greater capacity to intervene and buy government debt. Today, central banks have been scaling back such interventions.

With short-term financing increasing and central banks buying less government debt, refinancing risks are becoming more significant. This pattern is not expected to reverse quickly, which means debt levels could continue rising.

Are we therefore staring at a global debt crisis? What are the warning signs that sovereign debt has moved from manageable to dangerous levels?

The risks are certainly increasing, particularly for advanced economies. However, some economies are in a relatively better position to navigate these challenges.

For emerging economies, debt levels are also rising, mainly because of China. But if we look at countries such as India, despite the high stock of debt, the debt trajectory is expected to decline.

Ultimately, whether an economy moves into a crisis will depend on whether its debt is supporting growth and, equally importantly, how institutions respond to the situation.

But growth in the major economies is slowing, while geopolitical tensions and trade disruptions are increasing. Could a combination of high debt and stagflation eventually trigger a crisis?

The risks are definitely building up. Growth will be one of the major determinants of how debt levels evolve. To sustain high debt levels, economies need to revive growth, particularly productivity-led growth.

Japan is a good example. It experienced two decades of very weak growth and virtually zero inflation. But that situation has now changed. Inflation has risen, and that has forced an increase in policy rates.

This has put policymakers in a very narrow and precarious position. Bond yields are rising faster than central banks are moving. If central banks increase policy rates in line with market expectations, the cost could be weaker growth. If they move more slowly, currencies could come under pressure.

So there is a significant dilemma for policymakers. The path will have to be calibrated carefully, and institutions will need to respond promptly. There is a persistent risk for advanced economies, but they still have some options to reduce that risk if they act.

What actions can governments and institutions take to bring debt levels under control?

The key determinant will be whether these economies can revive their growth prospects. Productivity needs to improve, particularly in economies such as Japan, which has also lost some of its relative position in terms of trade competitiveness and its position in the global economy.

It would be better to reduce deficits through an organic growth path rather than through austerity measures. These economies need to focus on restoring growth while gradually bringing deficits under control.

One major fallout of high debt is higher interest payments. How will this affect government spending and ultimately the lives of ordinary people?

Interest payments as a percentage of revenue have not been as significant a problem for most advanced economies, apart from a few. It has traditionally been a bigger problem for emerging economies such as India and Brazil.

Emerging economies have substantial developmental needs that have to be supported by governments. If interest payments consume a large share of government revenues, the amount available for development spending gets squeezed. So the interest burden has a particularly significant bearing on emerging economies.

What about spending on ageing populations and climate-related requirements? Could high debt leave governments with less room for these priorities?

Social spending is already a major feature of advanced economies, while emerging economies will face similar pressures in the future.

Advanced economies previously had sufficient fiscal space because their interest costs were low. But that is changing. Rising yields will translate into higher interest payments, particularly for countries with shorter debt maturities.

These economies will now face a higher interest burden at the same time that social spending is increasing and climate-related spending is becoming necessary. Unless growth revives and generates additional revenues, these expenditures could result in more borrowing and therefore higher debt levels.

Coming to India, how will a debt problem in advanced economies affect us?

Higher global bond yields will automatically put pressure on emerging economies. They could trigger capital outflows and pressure on currencies. We have already seen such pressures this year.

We are likely to see this more frequently. Weaker global demand will also affect India. India's significant domestic economic component provides some protection against these external risks, but the impact of advanced economies will increasingly be felt through India's external environment.

India's sovereign debt is also elevated. How could this affect government spending on welfare measures and the lives of ordinary people?

India saw a significant increase in debt levels during an earlier phase, involving both central and state government debt. However, the situation has now moved towards fiscal consolidation.

The government has committed to a medium-term fiscal consolidation path, particularly at the Centre. But India's debt story has another important element: interest payments. They remain a large chunk of expenditure and create significant trade-offs for the government.

India therefore needs to mobilise higher revenues, through direct taxes as well as non-tax revenues. Disinvestment also needs to be accelerated.

The other element is the states. There is considerable diversity in the fiscal performance of different states. While some are performing well, others continue to face challenges. Unless these disparities are addressed, India's overall debt numbers may not come down significantly.

So fiscal consolidation is likely to continue, but how much debt levels decline will depend considerably on how effectively the federal mechanism is managed.

Finally, what is the way out of a debt trap, particularly for advanced economies whose problems can have ripple effects across the world?

It is important to correct the situation in advanced economies because of the ripple effects they have on the global economy.

The fundamental requirement is for institutions to revive growth. There are already rigidities in the fiscal structures of these economies. Social spending will increase, short-term borrowing is rising, central-bank intervention is declining and yields are increasing. At the same time, higher interest payments are reducing fiscal space.

The only sustainable way out is therefore to revive growth prospects. If institutions can restore productivity-led growth and create stronger economic activity, they can eventually avoid the kind of debt crisis that we are worried about.