• Costly Legacy of COVID-19: Government Debt
  • Lingering Liability
  • She-Cession

Latin writer Publilius Syrus once said: “A small debt produces a debtor; a large one, an enemy.” In macroeconomic parlance, investors and financial markets have often proven to be the enemies of heavily indebted nations. Debt at small or moderate levels can lubricate the wheels of economic activity, but in excess, it does more harm than good.

COVID-19 has throttled global economic activity. In response to its repercussions, governments and central banks around the world have announced support measures to prevent household and business insolvencies. Given the nature of the crisis, fiscal policy has played a prominent role. Nearly all countries have deployed fiscal measures since the onset of the pandemic. Two-thirds of them have scaled up their fiscal spending since April to ease the economic jolt. This has revived the debate around looming debt problems.

When the pandemic began, the world was already heavily indebted. We typically compare debt across countries by examining the ratio of government debt to gross domestic product (GDP); both parts of that ratio are moving targets. As the COVID-19 crisis took hold, automatic stabilizers cushioned the impact while governments cumulatively committed over $11 trillion in fiscal stimulus, increasing debt. At the same time, GDP contracted sharply. A growing numerator and shrinking denominator are making ratios surge.

Weekly Economic Commentary - Chart 1 - 08/07/20

The International Monetary Fund expects global average gross government debt to climb to 101.5% of GDP this year, up from 82.8% in 2019. In advanced economies, it is expected to surge to more than 130% of GDP, above even the levels seen during the 2008-2009 financial crisis. In emerging markets (EMs), it is predicted to rise to 63% of GDP.

Advanced economies are accruing large sums of debt, but emerging and low-income economies face bigger struggles in servicing their debt obligations. More than 100 low- and middle-income nations have to pay a combined $130 billion in debt service this year, half of which is owed to private creditors. Many of these countries have fragile economies with weak fiscal buffers and plummeting export revenues. While debt troubles are compounded for some nations by past economic or financial shocks, others are simply struggling because of their addiction to debt and mismanagement of their economies.

External support and strong multilateral cooperation are needed to help financially vulnerable nations combat the crisis. Elevated debt levels will constrain the scope and effectiveness of government support during these unprecedented times, but a full-blown debt crisis will also drive cuts in government spending on social sectors, causing long-term economic disruptions. While the G20’s call for a moratorium on debt servicing for low- and middle-income countries was a welcome move, it is not enough. A few members of the G20 are also among those struggling with high debt. Restructuring of debt, particularly for some African and Latin American countries, appears to be the only way out from the current malaise.

“A debt crisis in even a small economy has the potential to send shockwaves to other parts of the world.”

A debt crisis can lead to losses for financial institutions and, in turn, compromise the stability of financial systems, at home and abroad. Market turmoil and tighter financial conditions are some of the ways other countries can feel the effects of a debt crisis in a debtor nation. In major economies, a debt crisis that results in a sharp domestic economic slowdown can have adverse spillover effects on growth elsewhere.

Weekly Economic Commentary - Chart 2 - 08/07/20

Debt crises led to Latin America’s La Década Perdida (the lost decade) of the 1980s and Greece’s recent half-decade-long recession. In Japan too, excessive government debt has weighed on the economy, although there are a few other structural factors at play. A crisis in a small market economy can spiral into a significant event around the world, as shown by the 1997 Asian financial crisis. Thailand’s inability to pay its creditors due to surging debt and devaluation of its currency spread to other Asian countries like Indonesia and South Korea. Borrowers of foreign capital in those countries struggled to service their debt as currencies weakened and interest rates surged to contain capital outflows.

Of course, debt is not intrinsically bad for an economy, especially when bonds are issued for productive purposes like scaling up infrastructure. According to a World Bank study of 101 developed and developing economies, a debt-to-GDP ratio of 77% is the threshold at which debt starts to weigh on economic growth over time. Every percentage point of debt above the threshold costs 0.017% of annual real growth. In EMs, the threshold is 64%. This drag may sound small, but it can have a sizeable impact. The 130% debt-to-GDP ratio forecasted for advanced countries would weigh on their GDP growth by 0.9%, impairing an already-fragile recovery.

“Falling into debt traps is easy; climbing out is difficult.”