investment insights
Debt dynamics and default risks – assessing the dangers
Key takeaways
- Public debt levels are rising globally amid ageing populations, climate spending needs and a higher appetite for fiscal deficits; investor concerns tend to focus on the US
- We use a disciplined framework to assess debt risks, evaluating public and private sector debt, its use, cost, and the ability to finance it. We think current dynamics remain manageable
- While governments should tread carefully when running deficits, encouragingly, much of the recent debt increase has been for productive long term capital investment. Meanwhile, household and corporate balance sheets look generally strong
- We expect long-term real interest rates to remain below long-term growth rates in most major economies going forward, allowing some deficits to be sustainable. The US also has scope to gradually raise taxes should debt sustainability concerns escalate.
Is the US headed for a debt crisis? Public debt levels globally have risen sharply in recent years, and in the US, an election year is exacerbating the risks. Yet while the current pace of debt accumulation looks worrisome, several factors should temper investor concerns.
While investors often focus on the US, debt accumulation is a global phenomenon. Public debt has grown significantly in recent decades as a percentage of gross domestic product (GDP). From below 75% of GDP at the turn of this decade in developed economies, and 50% in emerging ones, the International Monetary Fund forecasts a rise to 120% and 80% respectively by 2028. In the US, the Congressional Budget Office (CBO) has already warned on the scale of the debt, which it projects rising to 192% of GDP by end-2053 if current policies continue.
Fiscal largesse in the pandemic was one driver of recent rises, in addition to structural reasons: ageing populations require more social security and healthcare spending; the sustainability revolution requires substantial investments in infrastructure and new green technologies. Geopolitical rivalries are also driving a capital spending race in strategic industries including technology, defence, and healthcare. We expect a fracturing world with increased appetite for high public deficits to persist, resulting in slightly higher structural inflation and ‘neutral’ interest rates in the years ahead.
Why are investors concerned about debt dynamics now? Although an interest-rate cutting cycle has started in many developed markets, high interest rates are still constraining their economies. Moreover, global growth is slowing, and 2024 is a big election year, adding to the risks of unsustainable spending promises. In the US, neither candidate for November’s presidential ballot has shown any eagerness to tackle the federal deficit. In the coming years, a Republican or Democratic president is likely to extend either tax cuts or tax credits respectively, driving debt higher.
Read also: US election scenarios and investment implications
We believe a disciplined framework is needed to assess debt risks. This means viewing public and private sector debt levels holistically within an economy. It also means assessing what this debt is being used for, the ability to finance it, and the cost of the debt, particularly relative to the growth rate of the economy. Below we assess the debt risks arising in major developed economies, especially in the US, and highlight three main reasons why rising public debt should not overly concern investors.
The ‘good’ versus ‘bad’ debt debate
While market focus tends to be on the size of the debt pile, we believe investors should focus more on what it is being used for. With the exception of pandemic handouts, much of the recent rise in public debt globally has been on productive long-term investment which will hopefully boost growth, rather than on the everyday running of government. In the US, which has led the investment charge, China, and to a lesser degree the European Union (EU), this includes much-needed upgrades of critical infrastructure as well as in some cases attempting to offset some negative environmental ‘externalities’ via clean energy subsidies.
In many advanced economies, including Japan, Germany and the EU more broadly, we judge there is still a substantial potential to increase such investments. In Germany in particular, public investment is constrained by the country’s constitutional rules, to the detriment of growth.
And while there is some historical evidence that government spending can deter or ‘crowd out’ private sector investment, so far in the US at least this has not appeared to be the case. The CHIPS and Science Act and Inflation Reduction Act (IRA) have instead tended to attract corporate investment into areas such as semiconductors and green technology, drawing capital into the vacuum of an emerging investment field. Although all governments need to tread carefully when increasing debt, the energy transition will require substantial investments which would be challenging for the private sector to shoulder alone. Estimates of climate mitigation and adaptation costs for advanced economies amount to between 1-3 percent of annual GDP, according to the Peterson Institute for International Economics.
Public sector versus private sector debt dynamics
Another reason why we believe debt levels in major economies are manageable is the differing dynamics of public versus private sector debt. The strong balance sheets of households and companies globally temper concerns around rising public debt considerably in our view as they create conditions for public debt to be absorbed by the household sector. Moreover, current account imbalances have improved markedly in several key economies in the last 15 years, notably in the EU, where the worst-hit economies in the 2009-2010 sovereign debt crisis were those that tended to have twin budget and current account deficits. Indeed, many countries with strong external accounts have historically run high levels of public debt with few problems, most notably Japan, where a strong domestic investor base makes debt crises much less likely.
Interest rates and growth
As long as the growth rate of the economy exceeds the interest rate on the debt, the government can run a permanent deficit while maintaining its debt at a constant percentage of GDP1. In several developed economies over much of the last century, the real interest rate has indeed remained below the growth rate. As noted earlier, an era of fracturing trade and supply chains and higher government debt is likely to result in somewhat higher real interest rates in future. However, in our view, long-term real interest rates are likely to remain below long-term potential growth in most major economies going forward, with the difference between the two slightly improving from current levels, especially in the US. This allows for some sustained government deficits over time without compromising debt sustainability. However, given the uncertainty around these estimates and their evolution in the future, fiscal space should still be used prudently; the recent pace of deficit growth cannot be sustained forever.
Meanwhile, we would anticipate investor concerns over the sustainability of US debt to continue sparking periods of volatility in the Treasury market. We view any form of US default as very unlikely, as if concerns on US debt sustainability were to escalate, the US also has scope to raise taxes, which are currently among the lowest relative to GDP among the major economies.
1 Suppose the government starts with a debt level at 100% of GDP. It pays a real interest rate of 1% per year on its debt and runs a deficit of 1% of GDP. If GDP grows at 2% every year, this will be enough to compensate both for the real interest expenses of the government (1%) and the deficit (1%). While the value of the debt will keep growing, it will remain constant as a percentage of GDP.
Important information
This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
Read more.
share.