Inflation-adjusted interest rates are well above the lowest levels recorded after the global financial crisis, while medium-term growth remains weak. Persistently high interest rates increase the cost of servicing debt, worsening fiscal pressures and posing risks to financial stability. Decisive and credible fiscal measures that gradually reduce global debt levels to more sustainable levels can help mitigate these dynamics.
Public debt sustainability
Debt sustainability depends on four key elements: primary balances, real growth, real interest rates and debt levels. Higher primary balances (the excess of government revenue over non-interest spending) and growth help ensure debt sustainability, while higher interest rates and debt levels make it more difficult .
For a long time, debt dynamics remained very moderate. This is because real interest rates were significantly lower than growth rates. This reduced the pressure for fiscal consolidation and allowed public deficits and public debt to drift upwards. Then, during the pandemic, debt rose further as governments rolled out large emergency support programs.
As a result, public debt as a fraction of gross domestic product has increased significantly in recent decades, in both advanced and emerging and middle-income economies. It is expected to reach 120 and 80 percent of production respectively by 2028.
As we face higher debt levels, the macroeconomic environment has become less favorable. Medium-term growth rates are expected to continue to decline due to lackluster productivity growth, weaker demographics, weak investment and lingering scars from the pandemic.
In this context, high long-term real interest rates could pose significant problems.
Short and long term rates
Public debate has focused on the real short-term interest rate, called r*, defined as the equilibrium interest rate at which an economy operates at its full potential while maintaining stable inflation. This equilibrium real interest rate has fallen dramatically in recent decades, driven by slow-moving structural variables such as demographics, demand for safe assets, productivity growth or distribution. revenues. As long as these factors continue to follow similar trajectories to those before the pandemic, equilibrium rates around the world will remain very low, as shown in an analytical chapter of the April 2023 World Economic Outlook.
However, even if r* remains low, the real cost of borrowing for the government, household and business sectors could be higher in the future. This is because they tend to borrow not for short periods, but for longer terms, and the associated long-term interest rates incorporate a risk premium – known as a term premium – which remunerates lenders which provide funds over an extended period.
The dynamics of r* and long-term rates can be illustrated in the case of US Treasuries, which serve as a global benchmark for bond markets. The dark blue bars show an estimate of r* in the United States. This figure has increased slightly recently, but remains at relatively low levels. In contrast, term premium estimates, represented by the light blue bars, have increased more markedly over the past year. In fact, the US Congressional Budget Office recently warned of the rising debt burden, noting that it could put pressure on the cost of financing.
Real long-term interest rates are therefore now comparable to their pre-global financial crisis levels, largely due to a higher term premium, and there are reasons to believe that this situation could persist:
First, the fight against inflation continues. Even if central banks consider easing policy, real rates will remain volatile for some time.
Second, the normalization of balance sheets initiated by the major central banks, commonly called quantitative tighteningcan also contribute to a rise in real term premiums by increasing the supply of longer-dated securities that must be absorbed by the market.
Third, rising interest rates likely also reflect expansionary fiscal policy and long-term fiscal concerns, at least in some countries. Loose fiscal policy can contribute to higher interest rates, particularly when inflation is high, by forcing central banks to tighten policy further to achieve their goals. Loose fiscal policy, if maintained, may also raise doubts among investors about long-term debt sustainability, leading to higher term premiums.
The key point is that, despite low breakeven rates, borrowers in the United States and the rest of the world could face a new normal with significantly higher financing costs than over the past decade .
Financial stability
If the improvement in the primary balance of States fails to compensate for the rise in real rates and the fall in potential growth, sovereign debt will continue to grow. This will test the health of the financial sector. First, the so-called “bank-state nexus” could worsen. When debt levels are high, governments have less ability to support struggling banks, and if they do, sovereign borrowing costs could rise further. At the same time, the more banks hold their country’s sovereign debt, the more their balance sheet is exposed to the sovereign’s fiscal fragility. Higher interest rates, higher levels of sovereign debt and a higher share of this debt on the banking sector’s balance sheet make the financial sector more vulnerable.
The bank-state nexus extends beyond advanced economies to developing economies and some vulnerable emerging markets. For example, the median banking system in low-income countries now holds around 13% of the country’s sovereign debt, double the share ten years ago.
Moreover, in a context of limited fiscal space due to high debt, pressure on monetary authorities to tolerate deviations from price stability in order to support public finances or the financial system could accentuate. This could be particularly relevant in countries with high public debt. If this were to happen to systemically important countries, financial market volatility could also increase, thereby increasing the cost of financing for businesses and households globally. Debt concerns, which would feed through to benchmark interest rates, could in turn distort asset prices and harm market functioning.
Finally, financial stability could come under strain in emerging markets with relatively weaker economic fundamentals, as high debt burdens make them much more vulnerable to pressures on capital outflows, depreciation of the interest rate exchange rate and increased expectations of future inflation.
Political implications
Some key policy implications arise from the above considerations.
Above all, countries should begin to gradually and credibly rebuild their fiscal space and ensure the long-term sustainability of their sovereign debt.
It is easier to rebuild fiscal space as long as financial conditions remain relatively accommodative and labor markets remain robust. It is more difficult to achieve this when market conditions are unfavorable. Sustainable fiscal consolidation will also allow for a faster reduction in policy rates, which should mitigate any negative effects on the macroeconomy. Even if substantial fiscal consolidation is necessary, this does not constitute a call for austerity. Too radical an approach to fiscal consolidation could have the opposite effect by pushing economies into recession. What is needed is a credible first installment, followed by subsequent, incremental steps in the same direction.
Second, to preserve financial stability, stress tests should adequately take into account the impacts on banks and non-banks of rising sovereign interest rates and possible market illiquidity crises. Modernizing market infrastructure to improve trading, price discovery and market depth is also a key policy priority, even in the most liquid sovereign debt markets.
Third, structural reforms must not be postponed. By strengthening future growth, they are the best way to help stabilize debt dynamics.
—Vítor Gaspar is director of the IMF’s Fiscal Affairs Department. Tobias Adrian is a financial advisor and director of the currency and capital markets department. Pierre-Olivier Gourinchas is economic advisor and director of the studies department.
Inflation-adjusted interest rates are well above the lowest levels recorded after the global financial crisis, while medium-term growth remains weak. Persistently high interest rates increase the cost of servicing debt, worsening fiscal pressures and posing risks to financial stability. Decisive and credible fiscal measures that gradually reduce global debt levels to more sustainable levels can help mitigate these dynamics.
Public debt sustainability
Debt sustainability depends on four key elements: primary balances, real growth, real interest rates and debt levels. Higher primary balances (the excess of government revenue over non-interest spending) and growth help ensure debt sustainability, while higher interest rates and debt levels make it more difficult .
For a long time, debt dynamics remained very moderate. This is because real interest rates were significantly lower than growth rates. This reduced the pressure for fiscal consolidation and allowed public deficits and public debt to drift upwards. Then, during the pandemic, debt rose further as governments rolled out large emergency support programs.
As a result, public debt as a fraction of gross domestic product has increased significantly in recent decades, in both advanced and emerging and middle-income economies. It is expected to reach 120 and 80 percent of production respectively by 2028.
As we face higher debt levels, the macroeconomic environment has become less favorable. Medium-term growth rates are expected to continue to decline due to lackluster productivity growth, weaker demographics, weak investment and lingering scars from the pandemic.
In this context, high long-term real interest rates could pose significant problems.
Short and long term rates
Public debate has focused on the real short-term interest rate, called r*, defined as the equilibrium interest rate at which an economy operates at its full potential while maintaining stable inflation. This equilibrium real interest rate has fallen dramatically in recent decades, driven by slow-moving structural variables such as demographics, demand for safe assets, productivity growth or distribution. revenues. As long as these factors continue to follow similar trajectories to those before the pandemic, equilibrium rates around the world will remain very low, as shown in an analytical chapter of the April 2023 World Economic Outlook.
However, even if r* remains low, the real cost of borrowing for the government, household and business sectors could be higher in the future. This is because they tend to borrow not for short periods, but for longer terms, and the associated long-term interest rates incorporate a risk premium – known as a term premium – which remunerates lenders which provide funds over an extended period.
The dynamics of r* and long-term rates can be illustrated in the case of US Treasuries, which serve as a global benchmark for bond markets. The dark blue bars show an estimate of r* in the United States. This figure has increased slightly recently, but remains at relatively low levels. In contrast, term premium estimates, represented by the light blue bars, have increased more markedly over the past year. In fact, the US Congressional Budget Office recently warned of the rising debt burden, noting that it could put pressure on the cost of financing.
Real long-term interest rates are therefore now comparable to their pre-global financial crisis levels, largely due to a higher term premium, and there are reasons to believe that this situation could persist:
First, the fight against inflation continues. Even if central banks consider easing policy, real rates will remain volatile for some time.
Second, the normalization of balance sheets initiated by the major central banks, commonly called quantitative tighteningcan also contribute to a rise in real term premiums by increasing the supply of longer-dated securities that must be absorbed by the market.
Third, rising interest rates likely also reflect expansionary fiscal policy and long-term fiscal concerns, at least in some countries. Loose fiscal policy can contribute to higher interest rates, particularly when inflation is high, by forcing central banks to tighten policy further to achieve their goals. Loose fiscal policy, if maintained, may also raise doubts among investors about long-term debt sustainability, leading to higher term premiums.
The key point is that, despite low breakeven rates, borrowers in the United States and the rest of the world could face a new normal with significantly higher financing costs than over the past decade .
Financial stability
If the improvement in the primary balance of States fails to compensate for the rise in real rates and the fall in potential growth, sovereign debt will continue to grow. This will test the health of the financial sector. First, the so-called “bank-state nexus” could worsen. When debt levels are high, governments have less ability to support struggling banks, and if they do, sovereign borrowing costs could rise further. At the same time, the more banks hold their country’s sovereign debt, the more their balance sheet is exposed to the sovereign’s fiscal fragility. Higher interest rates, higher levels of sovereign debt and a higher share of this debt on the banking sector’s balance sheet make the financial sector more vulnerable.
The bank-state nexus extends beyond advanced economies to developing economies and some vulnerable emerging markets. For example, the median banking system in low-income countries now holds around 13% of the country’s sovereign debt, double the share ten years ago.
Moreover, in a context of limited fiscal space due to high debt, pressure on monetary authorities to tolerate deviations from price stability in order to support public finances or the financial system could accentuate. This could be particularly relevant in countries with high public debt. If this were to happen to systemically important countries, financial market volatility could also increase, thereby increasing the cost of financing for businesses and households globally. Debt concerns, which would feed through to benchmark interest rates, could in turn distort asset prices and harm market functioning.
Finally, financial stability could come under strain in emerging markets with relatively weaker economic fundamentals, as high debt burdens make them much more vulnerable to pressures on capital outflows, depreciation of the interest rate exchange rate and increased expectations of future inflation.
Political implications
Some key policy implications arise from the above considerations.
Above all, countries should begin to gradually and credibly rebuild their fiscal space and ensure the long-term sustainability of their sovereign debt.
It is easier to rebuild fiscal space as long as financial conditions remain relatively accommodative and labor markets remain robust. It is more difficult to achieve this when market conditions are unfavorable. Sustainable fiscal consolidation will also allow for a faster reduction in policy rates, which should mitigate any negative effects on the macroeconomy. Even if substantial fiscal consolidation is necessary, this does not constitute a call for austerity. Too radical an approach to fiscal consolidation could have the opposite effect by pushing economies into recession. What is needed is a credible first installment, followed by subsequent, incremental steps in the same direction.
Second, to preserve financial stability, stress tests should adequately take into account the impacts on banks and non-banks of rising sovereign interest rates and possible market illiquidity crises. Modernizing market infrastructure to improve trading, price discovery and market depth is also a key policy priority, even in the most liquid sovereign debt markets.
Third, structural reforms must not be postponed. By strengthening future growth, they are the best way to help stabilize debt dynamics.
—Vítor Gaspar is director of the IMF’s Fiscal Affairs Department. Tobias Adrian is a financial advisor and director of the currency and capital markets department. Pierre-Olivier Gourinchas is economic advisor and director of the studies department.