This Update draws together the conclusions from the various pieces of research that we have published in recent weeks on how the fiscal costs of the crisis will be dealt with. In short, we are generally sanguine about the rise in government debt, which we think most countries can tolerate. But to keep interest rates on government debt low, financial repression could become more widely used in the years ahead. And in the few exceptions where the debt outlook is not sustainable, austerity, default or inflation will be seen.
- This Update draws together the conclusions from the various pieces of research that we have published in recent weeks on how the fiscal costs of the crisis will be dealt with. In short, we are generally sanguine about the rise in government debt, which we think most countries can tolerate. But to keep interest rates on government debt low, financial repression could become more widely used in the years ahead. And in the few exceptions where the debt outlook is not sustainable, austerity, default or inflation will be seen.
- As things stand, the coronavirus is set to prompt government debt ratios to rise by around 20pps on average. (See Chart 1 and also here for more on the fiscal costs of the crisis.) Those numbers could yet grow if the virus returns in widespread repeat waves or if economies are slower to bounce back than we expect. Governments have had little problem funding these rises in debt, in part because central banks have at the same time been hoovering up government bonds in their expanded asset purchase programmes. But looking further ahead, what will governments do about this rise in their debt?
- Least painful would just be to tolerate it. This would involve letting the debt be eroded gradually over time by economic growth, or even just letting the debt ratio remain at the higher level. As we discussed here, the fact that the current crisis has hit at a time of very low interest rates makes this strategy an option for a large number of countries. Indeed, as long as interest rates remain below GDP growth, these countries will be able to run small primary deficits while still stabilising or even reducing the debt ratio, although any plans for a significant loosening of fiscal policy will need to be put on ice. (See here and Chart 2.)
- To guard against the risk of a rise in interest rates, governments could skew issuance towards long-term debt. And financial repression (policies to force market interest rates artificially lower) will become more important, most likely via continued central bank asset purchase programmes and prudential requirements for financial institutions to hold government bonds. (See here for the implications of this for asset allocation.)
- In a few countries, though, interest rates are relatively high and growth prospects weak. Their government debt ratios are therefore on an unsustainable trajectory and financial markets are unlikely to give them the benefit of the doubt as they might, say, the US. These countries are mainly emerging markets (EMs), prime examples being Brazil and South Africa. But Italy is a notable developed market (DM) with unsustainable debt dynamics, while Greece is borderline in this camp too. (See here.) Financial repression might be used by some of these countries to lower interest rates. But even so, it is likely that this would need to be combined with one of three other options, none of them appealing, namely austerity, default or inflation.
- Inflating away the debt might seem like a quick fix, but the reality is very different. Not only might it not actually do much to reduce public sector debt ratios, but higher inflation would impose other serious costs on economies. (See here.) Indeed, where higher inflation does happen, this might just be accidental. That said, the deceptive appeal of higher inflation from a political perspective means that it might end up being pursued by weak governments, or out of desperation if other options have not worked.
Chart 1: Gross General Government Debt (As a of % GDP)
Chart 2: Primary Balance Required to Stabilise the Government Debt Ratio (EMs in blue, DMs in red)
Sources: Refinitiv, IMF, Capital Economics
- The other options are austerity (i.e. tax rises or government spending cuts to reduce the structural budget deficit) and default. The intellectual tide has turned against austerity in recent years. And we explained here why we doubt that the ingredients for a successful fiscal tightening are in place. There is also likely to be considerable voter resistance to more spending cuts. After all, the coronavirus will lead to pressure for governments to spend more (for example, on health and welfare safety nets), not less. And although there is appetite for tax rises on the rich and companies that have benefited from the crisis, this is unlikely to raise much money. But we could still see austerity in a few isolated cases, including Brazil and South Africa.
- While default can ultimately prove a good thing for a country by setting the stage for economic recovery, in the short run it is very costly and is usually accompanied by a banking and/or currency crisis. But in the current circumstances, it is arguably a more attractive option than usual, at least for many poorer EMs. (See here.) Moreover, default is all that is left once the other options have been ruled out! We expect some of the smaller EMs to go down this route, such as Angola, Zambia and Ecuador. (See here.) Further ahead, Nigeria and Ghana may do so too. Meanwhile, if the EC’s recent proposal for joint fiscal action marks a fundamental shift in its attitude towards debt mutualisation, then fiscal union may yet provide a way out for Italy. But the proposal on its own won’t get Italy out of trouble. So while we don’t expect Italy to default in the next couple of years, there is still a significant risk of a forced debt restructuring further ahead.
- Some think that there is another option, namely “printing” money to pay off the rise in debt – also known as “debt monetisation” or “helicopter drops”. But this is not a magic tool which policymakers have yet to deploy and can whip out as a last resort. In fact, when it comes to their macro-economic effects, debt monetisation and the current situation in which asset purchase programmes are facilitating fiscal expansions amount to pretty much the same thing. (See here.) Moreover, policymakers would still have to deal with any rise in inflation resulting from the permanent rise in the money supply. This might well involve measures equating to the reversal of the initial helicopter drop, meaning that the appearance of a permanent write-off of debt would have been illusory anyway. Alternatively, if they just let inflation take hold, debt monetisation would equate to inflating away the debt, with the associated costs that we mentioned earlier.
- In Table 1, we have grouped countries according to how they are likely to deal with their higher debt ratios. DMs are shown in red, EMs in blue. The table over-simplifies things somewhat, not least because countries might start with one strategy, but progress to another if that does not work. For example, we expect most DMs to “tolerate” their higher debt, but if the favourable gap between GDP growth and interest rates disappeared, some of them might change tack to austerity or even trying to engineer a rise in inflation.
- Nonetheless, it should give some idea of which countries are likely to follow which broad approach, at least in the first instance. As we explained earlier, most DMs and many EMs will just tolerate higher debt levels, perhaps aided by financial repression. Other countries, where possible, are also likely to pursue financial repression, often combined with austerity. This includes some of the major Latin American countries, South Africa and India. A number of poorer, smaller countries, and perhaps Italy, will instead join Argentina in defaulting on their debt. High inflation, at least in the foreseeable future, is only likely to be pursed/tolerated as a last resort and will initially only be seen in Argentina and possibly Nigeria.
Vicky Redwood, Senior Economic Adviser, firstname.lastname@example.org