Advanced economy debt challenges are serious, says Carmen Reinhart
The combination of higher debt levels with higher interest rates and higher risks including geopolitical risks, is tailor-made for accidents.
- Public debt levels are in unchartered territory.
- Private sector leverage is a potential contingent liability of the government.
- Debt overhangs this time around will have to include restructurings or defaults.
Having exited from an unusually low-for-long interest rate environment in March 2022, when US Federal Reserve Chairman Jerome Powell started raising rates, the debt challenges advanced economies face have become even more serious due to rising debt servicing costs, said Dr. Carmen M. Reinhart, Professor of the International Financial System at Harvard Kennedy School.
“We are in unchartered waters. Collectively, advanced economies are at record or near-record levels of public debt. Add the private sector leverage to that, and the potential for the realization of contingent liabilities is huge,” she said, speaking at Nomura Investment Forum Asia 2024 in Singapore on June 6.
Public debt in the US is at around 100% of GDP, and in Japan at 250%. Furthermore, in the event of a crisis, private debt often becomes public debt.
The period between the global financial crisis of 2008 and the start of Fed tightening was exceptional in that concerns about debt were largely dormant. After recovering from the crisis, even as the US started recording historically low levels of unemployment rates, there was no effort to reduce debt, said Dr. Reinhart.
Similarly, by 2012 and 2013, when the private sector had largely recovered, there was no substantive push by the monetary authorities to normalize policy and raise interest rates.
“The central banks responded aggressively to negative shocks, but there was no substantive policy reversal in the recovery phase. When the COVID shock hit, central bank balance sheets ratcheted up (again). On the fiscal side, the pandemic was accompanied by a ratcheting up of public debt. The very long accommodation by central banks, which kept real interest rates consistently negative also facilitated a disregard for concerns about debt and induced the private sector to lever up steadily.”
The combination of higher debt levels with higher interest rates now and higher risks globally including geopolitical risks, is “tailor-made for accidents,” she said.
There is some complacency that economic growth is a way out of high public debt levels, but in the majority of cases, growth has not proved sufficient to achieve debt reduction. The other orthodox approach to reduce debt/GDP ratios is through fiscal adjustment, but there hasn’t been any indication that is likely in the US or Japan.
Financial repression, or engineering ultra-cheap ways of borrowing (negative real interest rates) is an unorthodox way countries tend to fight their debt woes. But the financial repression tax may not be nearly enough at such high levels of debt, said Dr. Reinhart.
Ultimately, debt overhangs this time around will have to go in for debt restructuring and defaults. These can be explicit or nuanced such as a reduction in the delivery of benefits from social security and other government transfers, for instance, she said.
The Bank of Japan is in a tough spot, as Japan’s financial sector holds a significant (global record) share of government debt. The BoJ is being cautious in raising rates because it would want to smooth out the impact of rate hikes on the balance sheets of these financial institutions, she said. But this leaves the door open for currency depreciation especially when interest rates elsewhere are higher. “Since you don’t want to use an interest rate defense, you rely on intervention in the currency market. That is a buying time strategy – not a sustainable policy.”
In the US, debt issuance has shifted to shorter term treasury bills. “It’s something that you can do in the short run, but it leaves you open to rollover risks at a time of record debt. Typically, there is a rise in the share of short-term maturity debt ahead of a crisis,” said Dr. Reinhart.
Meanwhile, for China, whose central government debt levels are at 60% of GDP, a significant concern is the contingent liabilities of sub-sovereigns or provincial debt, she said. Then there are financial sector liabilities connected to the weakening property sector. Also, much of the international debt extended as part of its Belt and Road Initiative has soured, adding to the debt woes.
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