Global Sovereign Debt Is Turning "Japanification." How Can We Assess Major Countries' Fiscal Sustainability?

Public debt-to-GDP levels in developed markets reach multi-decade highs and are well above historical averages following successive shocks from the 2008 financial crisis to the pandemic. Normative judgements about the 'right' or 'safe' level of government debt are contested. The period of low interest rates after the 2008 financial crisis suggested that high debt levels may not constrain fiscal space, and have posed less risk than previously thought.

However, the recent rise in inflation and policy rates is refocusing attention on debt dynamics as interest costs increase and fiscal policy adjusts after the pandemic. It is important to know whether or not high debt burdens constitute a risk, and whether they can be reduced.

A recent research by Goldman Sachs analyst George Cole released on Sept. 12 pointed out that changes in the level of sovereign debt stress depend on four factors: interest rates, primary fiscal balances, real GDP growth, and inflation rate.

Inflation and real economic growth contribute to debt reduction; high interest rates increase debt stress. The primary balance shows the most variance, at times contributing to higher debt and at others to debt reduction.

The key indicator for debt dynamics is described by r-g, where r is the real interest rate and g is the real growth rate. If r-g is negative, then debt will fall, or could support a modest primary deficit. If r-g is positive, then debt ratios will rise in the absence of primary surpluses.

In the immediate post-war period, r-g was negative due to a combination of low interest rates, strong productivity growth, and unexpected inflation surprises. On average, this was also a period characterized by falling debt-to-GDP ratios.

From the 1980s until 2000, r- g was positive, and debt began to rise. From 2000 onwards, r-g has typically been negative. Despite this tailwind, debt ratios have increased, on average by 40% of GDP since 2007 as governments have responded to successive shocks resulting in substantial primary deficits.

Based on the above factors influencing the debt level, Goldman Sachs compared different countries using these three indicators: r-g, national debt interest/GDP, and whether there is a double deficit (fiscal deficit + current account deficit).

The results showed Spain is a "poor student" in all three indicators, while Italy and the US perform poorly in two indicators, among which America's r-g pressure is not great because of strong economic growth, but US interest expenditure pressure is high and there are double deficits. Japan performs poorly in one indicator (future interest burdens growth is fast). Canada performs well in terms of these indicators.

Japan provides an example of high debt peaceably coexisting with low interest rates. However, given current high inflation, wider deficits, and rising interest costs, it seems less likely that we return to the era of structurally low interest rates in the US, UK or Europe, Cole noted.

Cole warned that current fiscal projections and market interest rates on average do not point to declines in debt-to-GDP ratios across developed countries.The only solution is to promote fiscal consolidation and adopt a more balanced government spending.