Chart of the day
Consequences of runaway debt accumulation
Continuing from Friday ……………..
Two of the key questions that are begging answer from the central bankers infusing trillions of dollars in fresh liquidity in the global financial system and the governments borrowing incessantly to further their populist agenda, is what will be the impact of this debt burden on the potential economic growth? and How the perpetually slow growth will impact the demography, i.e., whether the world will follow the demographic trends of Japan and grow old?
As per the World Bank report titled Global Waves of Debt – Causes and Consequences, “Amid record high global debt, low interest rates and subpar growth have led to an intense debate on whether the recent rapid increase in debt is reason for concern. Some argue that countries, especially those that issue reserve currencies, should take advantage of low interest rates to borrow more to finance priority expenditures. Others caution that high debt weighs on long-term growth, by increasing the risk of crises, limiting the scope for countercyclical fiscal stimulus, and dampening private investment.”
The report further highlights that, “Although the focus of this debate has been mainly on advanced economies, similar issues are also faced by EMDEs. Many of these economies have also borrowed heavily and, in many cases, hard-won reductions in public debt ratios prior to the global financial crisis have largely been reversed over the past decade. The tradeoffs EMDEs face are actually even starker, in light of their histories of severe debt crises even at lower levels of debt than in advanced economies and their more pressing spending needs to achieve development goals and improve living standards.”
The importance of public debt in growth economics can hardly be overemphasized. Government investment in physical and human capital provides an important foundation for stronger economic growth over the long term. It helps in attaining the ideal goal of full employment and optimum capacity utilization on sustainable terms.
It is important to note that despite substantial progress over the past two decades in many areas, several Sustainable Development Goals (SDGs) remain well out of reach. As per the World Bank estimates, to meet the SDGs, EMDEs have large investment needs: low- and middle-income countries face aggregate investment needs of $1.5–$2.7 trillion per year—equivalent to 4.5–8.2 percent of annual GDP— between 2015 and 2030 to meet infrastructure-related SDGs, depending on the effectiveness of this investment, accompanying policy reforms, and the degree of ambition in meeting the SDGs. Higher debt level for emerging and underdeveloped economies is necessary in most cases.
Besides, temporary debt accumulation can also play an important role in helping to minimize and reverse short-term economic downturns. During recessions, borrowing financed government spending or tax cuts can provide stimulus to support demand and activity.
However, it is important to do an intensive cost benefit analysis of every dollar in new debt. The cost of debt is not only the interest payable on such debt; but also the impact of the debt on the future growth potential and changes in socio-economic structures.
During the post-crisis period, the cost of government borrowing in terms of rate of interest has been historically low, for both advanced economies and EMDEs. Further, demographic shifts and slowing productivity growth are expected to contribute to a further secular decline in real interest rates in advanced economies, continuing a multi-year trend. However, if a sudden increase in global borrowing costs occurs; the sustainability of high debt in some countries will be tested. A failure in this test could bring disastrous consequences.
As per the World Bank, “Debt sustainability has deteriorated since the global financial crisis both in advanced economies and in EMDEs. In advanced economies, debt-reducing fiscal positions (i.e., positive sustainability gaps) in 2007 turned into debt-increasing fiscal positions (i.e., negative sustainability gaps) from 2008. Subsequently, sustainability gaps narrowed and, in 2017, returned to debt-reducing positions. In EMDEs, debt-reducing positions in 2007 turned into debt-increasing positions in 2015.
In commodity-exporting EMDEs, this deterioration partly reflected the sharp growth slowdown that came in the wake of the steep slide in commodity prices. Subsequent recoveries in commodity prices and economic activity helped improve debt sustainability in these economies and, by 2018, fiscal positions in commodity exporters had become debt reducing. In commodity-importing EMDEs, fiscal positions have remained weak as a result of fiscal stimulus implemented during the global financial crisis, chronic primary deficits, and, in some cases, anemic post-crisis growth, leading to debt-increasing fiscal positions in 2018.
High debt constrains governments’ ability to respond to downturns with countercyclical fiscal policy. This was the case during the global financial crisis: fiscal stimulus during 2008-09 was considerably smaller in countries with high government debt than in those with low debt. This is one of the reasons why weak fiscal positions tend to be associated with deeper and longer recessions, a situation that worsens if the private sector also falls into distress and its debt migrates to government balance sheets as the government attempts to rescue private enterprises. Reducing the effectiveness of fiscal policy. High government debt tends to render expansionary fiscal policy less effective. Specifically, high government debt can reduce the size of fiscal multipliers through two channels.
With higher debt typically comes higher debt service. Spending on higher debt service needs to be financed through some combination of increased borrowing, increased taxes, and reduced government spending. Spending cuts may even include spending on critical government functions such as social safety nets or growth-enhancing public investment. Separately, high and rising government debt may raise long-term interest rates and yield spreads. High debt could also create uncertainty about macroeconomic and policy prospects, including risks that the government may need to resort to distortionary taxation to rein in debt and deficits (IMF 2018a; Kumar and Woo 2010). Higher interest rates and uncertainty would tend to crowd out productivity-enhancing private investment and weigh on output growth.
As per the available empirical evidence, a return to monetary policy normalization in advanced economies could raise borrowing costs (Ruch 2019). If there was a rapid increase in policy interest rates, as happened in the first global wave of debt accumulation, it could be accompanied by large currency depreciations in EMDEs that would sharply increase debt service burdens for foreign currency-denominated debt (Arteta et al. 2016). It would also be likely to trigger a turn in investor sentiment that would especially affect those EMDEs with large foreign participation in local bond markets, which in some economies now exceeds 30 percent of government bonds. Although the normalization of monetary policy in USA and EU is not visible on horizon, occurrence of this even could spell disaster for many emerging economies.
It is pertinent to note that during crisis it does not take much for the private debt to become public debt. Large private sector losses, including losses threatening bank solvency, and the materialization of contingent liabilities, including those of state-owned enterprises, can lead governments to provide substantial financial support. We have seen glimpses of this phenomenon in India in past 10 years.
During the current wave of debt, potential growth in EMDEs has also declined, because of slower productivity growth as well as demographic change. Productivity growth has declined as investment growth has slowed, gains from factor reallocation have faded (including the migration of labor from agriculture to manufacturing and services), and growth in global value chains has moderated. Slower investment growth has tempered capital accumulation. Demographic trends have become less favorable to growth, since the share of working age populations in EMDEs peaked around 2010. In case of India it is expected to peak in this decade. Burgeoning debt could therefore a major issue for these economies.
(Most of this write up is reproduced from the Word Bank Report titled Global Waves of Debt – Causes and Consequence. The copyrights are acknowledged.)