The rising risk of global debt addiction
Lack of macro policy space due to stretched government balance sheets will lead to higher loss of output in case of financial stress
The global economy is likely to expand at its fastest pace since 2011, according to new estimates from the International Monetary Fund (IMF). The ongoing synchronized cyclical upswing is good news, but underneath this impressive growth is a risk that is perhaps not being adequately recognized. The global economy’s continued addiction to debt could pose financial stability and growth risks going forward. The latest Fiscal Monitor of the IMF, released last week, noted that global debt at the end of 2016 was at 225% of the gross domestic product (GDP), which is 12 percentage points higher than the previous peak of 2009, when governments were on a deficit spending spree to prevent economic collapse.
Countries in all income groups have added to their debt pile, with emerging markets taking the lead. Private sector debt has doubled in the last decade in emerging markets. China alone has added about three-fourths of the total increase in global private debt. There are at least four broad reasons why policymakers across the world should be worried about rising global debt and its consequences.
First, interest rates in the US will continue to rise. The Federal Reserve expects to raise interest rates gradually, with two more hikes this year. However, it might end up raising interest rates faster than anticipated, as inflation is now expected to top the 2% target. The yields on two-year US government bonds have risen to their highest level since the financial crisis. Further, the increase in the US budget deficit at this stage of the business cycle could also compel the Fed to raise rates at a faster pace. Higher interest rates in the US will inevitably tighten financial conditions in global markets and affect the ability of both governments and the private sector to service debt. A commensurate rise in risk premium will further complicate matters for borrowers, especially in emerging market economies. A sharp reversal of capital could also pose a risk to financial stability.
Second, the US economy is witnessing one of the longest expansion cycles on record. While it is possible that economic expansion will continue in the foreseeable future, it is unlikely to last forever. A recession or a slowdown in the US in coming years will affect global growth. The IMF has projected medium-term global growth at 3.7%, compared to 3.9% in the current year. Consequently, slower revenue growth for both governments and the private sector will again make debt servicing more difficult. It is also possible that growth will moderate, with relatively tighter financial conditions compared to the last decade.
Third, higher government debt across economies would increasingly impede the ability to spend in areas such as infrastructure, which can push potential growth. General government debt in emerging markets and middle-income economies is expected to go up from 37.4% of GDP in 2012 to 52.9% of GDP in 2019. It is projected to rise at least till 2023. Continued higher government borrowing will put pressure on the cost of money and crowd out private investment. Therefore, an elevated level of government debt could be a drag on growth in the medium-to-long run. For instance, bond yields have gone up in India in recent months, partly owing to the higher supply of government bonds, which is said to be pushing corporate borrowers out of the bond market and will affect growth in the medium term.
Fourth, as also noted by the IMF, higher government debt also means less policy space to fight possible stress in the financial system or an economic downturn. Economists Christina D. Romer and David H. Romer have shown in their 2017 paper Why Some Times Are Different: Macroeconomic Policy And The Aftermath of Financial Crises, which looked at 24 advanced economies in the post-war period, the available fiscal and monetary policy space significantly affects the aftermath of a crisis. It shows that the decline in output is less than 1% after a crisis if a country has both monetary and fiscal policy space. But the output declines by about 10% when it doesn’t have the policy space to respond. Given the state of fiscal and monetary policy, especially in advanced economies, an unknown shock to the financial system could be difficult to handle and lead to severe output loss.
The global economy has added more debt to recover from the 2008 financial crisis, which was essentially caused by higher leverage. A higher level of debt is a potential source of risk and needs policy attention. Therefore, unlike what the US government is doing, it is important that policymakers carve out policy space when the going is good. Lack of macro policy space due to stretched government balance sheets will lead to higher loss of output in case of financial stress, and sustaining the cyclical recovery in the global economy will be far more difficult.
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