Governments are awash in debt. There are no signs that borrowing will let up anytime soon with COVID-19 still on the march, infrastructure systems in need of investment, military budgets at lofty levels, and pension and other social obligations mounting.
Some economists point out that the COVID-19 paradigm shift, which has given central banks and governments more control over capital allocation, may provide an impetus to undertaking development opportunities such as modernizing infrastructure or accelerating the transition to energy-efficient economies.
However, the debt trends beg some tough questions. Is further debt accumulation sustainable, and what are the risks for major economies, financial markets, and taxpayers?
New high ground and not done yet
Public debt has ballooned since the COVID-19 pandemic began, with that of advanced economies jumping almost 27 percent as a group since Jan. 2020, according to the International Monetary Fund (IMF). This debt level now sits beyond what was reached after World War II, at greater than 120 percent of GDP.
Global debt is tamer at 102 percent of GDP because many of the largest emerging economies have lower official debt burdens. However, this is also a record level.
All of these figures actually understate the situation. Obligations are higher when off-balance sheet debts, in the form of future social promises, are taken into account.
For example, the U.S. data that is used in most global estimates just tallies the debt that has officially accumulated on the books. This $27 trillion debt pile, as estimated by the Treasury Department, represents 124 percent of U.S. annual GDP. The debt load would be much higher if off-balance sheet promises such as Social Security (pension) and Medicare (health care) were factored in—these are future expenditures the government is obligated to pay by law, unless current laws are changed.
Advanced economies’ debt is expected to eclipse the World War II high
Average debt-to-GDP ratio in country groupings (% of GDP)
Source - RBC Global Asset Management, International Monetary Fund (IMF); data as of June 2020 and uses IMF estimates for 2020 and 2021
If the present value of these off-balance sheet items for the next 75 years were included, the debt would soar from $27 trillion to $137 trillion, according to the nonpartisan group Truth in Accounting. Even if these social and health care “obligations” are eventually reduced by means testing and/or in other ways, as many Americans presuppose will ultimately occur, they could still represent a meaningful share of the future public debt load.
Such off-balance sheet obligations, whether massive in size or much reduced, would also cause advanced economy and global debt to jump since the U.S. debt represents the highest share of both—by far.
The U.S. and Japan account for half of total global government debt
Share of global government debt by country
Source - International Monetary Fund, World Economic Forum; 2018 data, does not include off-balance sheet obligations
The increase in public debt loads seems justified as the COVID-19 economic shutdowns earlier this year were imposed by governments themselves, and created an enormous vacuum for many households and businesses, with the output loss, at the worst moment in the spring, approaching that experienced during the Great Depression. This explains why governments in developed countries moved quickly to fill the gap, trying to ensure economic ties were maintained, and to keep individuals employed and businesses solvent during the shutdown. Their measures have arguably helped economies recover more quickly than they otherwise would have.
Higher debt levels not necessarily a systemic risk
A separate issue to consider in the debt load discussion is the role of household debt and, specifically, the balance between household and public debt.
For some countries the household debt burden is currently a greater concern than public debt. For example, in the decade following the global financial crisis (2009–2019) Canada has seen household debt rise from 93 percent of GDP to 106 percent, while federal debt fell from a peak of 47 percent of GDP to 40 percent prior to the COVID-19 surge.
In the U.S., it’s the reverse. Consumer debt used to be much higher than government debt, but the former has retreated while the latter has continued to swell.
Trading places: As U.S. federal debt has risen, household debt has declined
Debt as percentage of U.S. GDP
Note: CBO federal debt data differs from Treasury Department data, which is cited in the text of this article and is a broader measure of federal debt
Source - RBC Wealth Management, Bloomberg, Congressional Budget Office (CBO); data as of September 2020
U.S. household debt obligations fell from nearly 100 percent of GDP to around 75 percent in the decade that followed the 2008–09 global financial crisis, largely driven by a reduction in mortgage-related debt (brought on by bankruptcies, in some cases, as the housing bubble burst). Over the same period, publicly held federal debt rose from around 50 percent to about 80 percent.
Our fixed income strategist asserts that “while some may harbor reservations and fears about rising debt levels, that shift should be a net-positive in terms of systemic risks, in our view, as the federal government obviously has greater capacity and more avenues to address debt service than the U.S. consumer, not least of which is the ability to print its own money.”
He goes on to add, “We continue to believe that deficits and overall levels of publicly held U.S. federal debt are not a material concern for investors over the near and intermediate term. Higher Treasury supply alone is not sufficient to send yields higher, based on historical correlations. Factors such as the path of Fed policy rates, GDP growth, and inflation expectations matter to a much greater degree.”
Debt servicing costs will reduce budget flexibility, but only in the long term
Another factor that makes the situation tolerable for the time being is that debt service costs for most governments are relatively low and manageable due to prevailing ultralow interest rates.
U.S. federal debt costs have actually declined this year despite the total amount of outstanding debt surging higher. That is because there continues to be existing government bond issues carrying much higher coupons that are maturing and being refinanced at today’s ultralow rates. These debt costs are set to move even lower through 2023 and remain low for much of this decade, according to Congressional Budget Office estimates.
U.S. federal debt costs manageable
The Fed’s ultralow interest rate policies allow interest expenses to decrease even as total debt mounts
Source - RBC Wealth Management, Congressional Budget Office; data as of September 2020
For its part, RBC Global Asset Management’s forecast over the next decade does not anticipate a large increase in the cost of servicing the debt, or the share of GDP spent on interest payments. The latter should remain relatively subdued, only gradually moving up to 2.5 percent of GDP more than a decade down the road as the debt load increases. In other words, it will not take much more of GDP to pay for servicing the debt than it did in the last two decades, when it averaged some 1.5 percent of GDP. The cost of servicing the debt was higher in the 1980s and the first half of the 1990s, when more than three percent of GDP was spent on debt servicing. With debt servicing costs set to increase only modestly as a percentage of GDP, G20 nations are unlikely to default, in our view. However, their choices on how to use their budgets will likely become gradually more constrained.
Beyond this decade, for the 2030s, as public debt loads swell, RBC Global Asset Management estimates that U.S. debt servicing as a share of GDP will rise to something greater than the average of the last several decades, limiting the government’s ability to cut taxes or spend on desirable government programs.
Lack of will
Within advanced democracies, we think it will be difficult for elected and appointed officials as well as voters to resist the temptation of further debt accumulation. The path of least resistance seems to be pointing toward increasing fiscal spending, not restraint.
Policymakers lack the incentive to address the issue given borrowing costs in the market have remained low despite debt levels spiking. In all likelihood, debt loads will be forced ever higher as further stimulus measures for the COVID-19 crisis are implemented and other crises inevitably hit.
The U.S. may find it easy to turn a blind eye to its growing debt because the U.S. dollar’s status as the world’s reserve currency means there is underlying demand from institutional investors and governments globally for the debt America issues. Given this ease to finance itself and to print money, the U.S. may be even less inclined to reduce debt levels or meaningfully lower its rate of debt accumulation.
In Europe, recent moves toward some form of debt mutualization (i.e., all members are collectively responsible for the debts issued to fund spending anywhere in the EU) could further unify member countries, binding them not just by joint monetary policy, but by fiscal policy as well. This could make higher debt levels more sustainable in the eyes of investors.
As for emerging markets, those countries with high debt loads that are also heavily dependent on commodity prices could become more susceptible to debt restructurings or defaults.
Consequences: Lower interest rates, slower growth
Persistent debt accumulation will likely be one more factor that will keep central banks suppressing interest rates over the medium and longer term, further burdening savers and fixed income investors.
According to RBC Global Asset Management, interest rates will need to be permanently lower than before, given that public debt loads will likely permanently remain higher and given there is no obvious, relatively painless way to pay those debts down. Interest rates should rise over time, but they will probably be lower than would otherwise have been the case.
Despite low interest rates, the debt levels may well cap economic growth.
Japan is a case in point. The country has accumulated high levels of debt over the years, reaching 238 percent of GDP in 2018, according to Japan’s Ministry of Finance. It has hovered above 200 percent for 10 years. This situation and the decline of the working-age population along with the commensurate rise of the retiree population are viewed by many as the primary reasons why the country has struggled with anemic economic growth for some 30 years. Japan’s real GDP averaged 1.3 percent growth per year from 2010 through 2019, whereas China and the U.S. averaged 7.7 percent and 2.3 percent growth, respectively.
On the other side of the coin, Japan has proven that higher debt levels can be more sustainable than one might think, at least for a time, although undesirable due to the drag on economic growth.
Higher for longer
There seems to be greater acceptance of high debt loads in the financial community and among government officials in the wake of the pandemic crisis. From a pure “balance sheet” perspective, we believe higher debt loads are manageable in the near and intermediate term. However, at a minimum, high debt levels, while sustainable for the time being in most advanced economies, will eventually restrict governments’ budgetary flexibility and are likely to result in higher tax rates, in our view.
High debt loads will likely also be a powerful incentive for policymakers to further suppress interest rates. This is a key reason we recommend that investors consider strategies for a low interest rate environment that may linger for much longer than one might think is reasonable. (We explore such strategies in “Adapting fixed income investment strategies in an ultralow rate world.”)
The more that debt and debt-to-GDP mount over the longer term, the more governments and taxpayers will enter uncharted territory. It’s unclear to us where the tipping point is between manageable and unmanageable debt loads. So far, markets are behaving as though any tipping point is a long way from here.
Non-U.S. Analyst Disclosure: Frédérique Carrier, an employee of RBC Wealth Management USA’s foreign affiliate RBC Europe Limited, contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since they are not an associated person of RBC Wealth Management, they may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.