Home / News / India /  Low interest rates don’t make spending risk-free

A negative interest rate–growth differential since the 2008 financial crisis could tempt governments to spend more. But such a step could be risky for countries with higher debts as the differential could very well turn positive again, new research warns.

In a working paper published by the International Monetary Fund, Lian and others examine trends of interest rates, growth and public debt of 17 advanced economies since 1950. Using the data, the paper says fiscal expansion is risky because even before the covid-19 pandemic, public debts were at historic highs.

When the interest rate–growth (r-g) differential is negative, debt-to-GDP ratio is expected to decline, making public debt more sustainable. Countries consider this a favourable time for fiscal expansion. But the study finds that historically, periods with negative r-g differentials were short-lived when debts were high.

Countries with higher debts return faster to a positive r-g differential, the authors find. Countries with high public debt suffer in both good and bad economic situations, they say.

Exposure to negative growth shocks can be more worrisome for countries with higher share of foreign currency debt. Even a growth rate 1% slower than expected can result in interest rates shooting up by 155 basis points, the paper finds. As a result, increased borrowing costs can limit the country’s fiscal capacity to support growth.

The authors conclude that fiscal expansion in times of negative r-g differential needs to take into account the debt levels. Especially in the current scenario, when countries are vulnerable to negative shocks from the covid-19 pandemic, expansionary policies hold the risk of reversal to a positive r-g gap and thereby, unsustainable debt levels.

Also read: The risks of high public debt despite a low interest rate environment

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