What primary balances are needed to stabilise debt ratios? - Capital Economics
Global Economics

What primary balances are needed to stabilise debt ratios?

Global Economics Update
Written by Vicky Redwood

Public sector debt to GDP ratios are going to rise sharply and, in most cases, governments can tolerate this. But to retain the faith of financial markets, they might still need to make sure that debt is on a stable trajectory. For most, this is not a problem; with interest rates lower than GDP growth, they will in fact still be able to run small primary deficits. But in some countries, these deficits will still have to be smaller than the ones seen going into this crisis. Moreover, a notable few will need to run primary surpluses.

  • Public sector debt to GDP ratios are going to rise sharply and, in most cases, governments can tolerate this. But to retain the faith of financial markets, they might still need to make sure that debt is on a stable trajectory. For most, this is not a problem; with interest rates lower than GDP growth, they will in fact still be able to run small primary deficits. But in some countries, these deficits will still have to be smaller than the ones seen going into this crisis. Moreover, a notable few will need to run primary surpluses.
  • We have pointed out elsewhere that, in recent years, interest rates on government debt have been below GDP growth in most developed economies and many emerging markets. As long as this continues, then interest costs as a share of GDP will be falling. This gives governments scope to run modest primary budget deficits (i.e. deficits excluding interest costs) while stabilising, or even reducing, the public sector debt ratio.
  • How big a deficit they could run while keeping the debt ratio on a sustainable course obviously depends on what assumptions we make for the gap between interest rates and GDP growth going forward. To keep things simple, Chart 1 shows what happens if we just take the average of the gap between 10-year bond yields and nominal GDP growth seen over the past decade. We have taken our debt to GDP forecast for 2022 as our starting point.
  • Most of the major developed economies would have scope still to run a primary deficit of at least 1% of GDP while stabilising their debt ratio. For example, the UK and US could run deficits of about 1.5% of GDP, Japan 2% and China about 3.5%. That said, some of this group, including the US, were running bigger deficits than this going into the crisis. If these countries wanted to stabilise their debt trajectories, they would still have to tighten fiscal policy a bit to shrink their primary deficits.
  • This would especially be the case if it turns out that this crisis has caused some permanent damage to the economy, resulting in a structural deterioration in the public finances compared to before the crisis. And at some point, the favourable gap between nominal GDP growth and interest rates might narrow or disappear, for example, if rising inflationary pressures resulted in higher interest rates.
  • For the other group of countries where interest rates have been above nominal GDP growth, the reverse applies. Assuming interest rates remain above GDP growth, their interest costs as a share of GDP will be rising. Accordingly, to keep the debt ratio stable, they will need to be running primary budget surpluses.
  • Moreover, the higher the debt ratio, the bigger the primary surplus needs to be as a share of GDP in order to keep the debt ratio constant. (See Table 1.) This is particularly pertinent for peripheral euro-zone countries which will have especially high debt levels after this crisis, including Greece (210% by 2022 on our forecasts), Italy (162%) and Portugal (147%). These countries need to run faster just to stand still.

Chart 1: Government Primary Balance (As a of % GDP)

Table 1: Primary Balance As a % of GDP Required to Stabilise the Debt Ratio* (Red – deficit, Blue – surplus)

Sources: IMF, Capital Economics. *Based on nominal GDP growth of 5%.

  • Chart 2 shows the primary surpluses these countries would have to run to keep the debt level stable. Portugal, Italy, Brazil, Spain and South Africa would have to run surpluses of between 1% and 4% of GDP. At least most of the Southern European countries were already running primary surpluses before the crisis. But these surpluses would still need to be increased. Meanwhile, Brazil, Spain and South Africa were running primary deficits in 2019, indicating that a big tightening of fiscal policy would be required to run the primary surpluses required to stabilise the debt ratio.
  • Admittedly, using the ten year average of the gap between bond yields and GDP growth probably gives an overly pessimistic picture for some of the peripheral euro-zone economies which have turned things around somewhat over the last four or five years. In Chart 3, we show what happens if we instead use the gap between the actual (or effective) interest rate paid on the stock of government debt and GDP growth, both for 2019. For most countries, this does not change the big picture. However, as we would expect, it paints a more optimistic picture for Greece, Portugal and Spain (and a more pessimistic one for India). On this basis, Portugal and Spain, circled in Chart 3, appear to be able to run primary budget deficits of around 2% of GDP.
  • That said, we would not be too reassured by this. After all, when the current suspension of fiscal rules ends, both countries will come under pressure from the EU to actually lower, rather than just stabilise, their debt ratios. And reducing their debt ratios by, for example, 20pps over the next decade would require Spain and Portugal to run a primary surplus of about 0.5%. While Portugal was running a primary surplus before the crisis, Spain was running a deficit.
  • The upshot, then, is most countries do not have to tighten their belts significantly to put the debt ratio on a sustainable path after this crisis. To stabilise debt ratios beyond 2022, they just need to stick to roughly the same primary balances as they had going into this crisis. Indeed, some (including Germany) could get away with bigger primary deficits/smaller surpluses than they had before the crisis. Nonetheless, there are some countries whose pre-virus fiscal stance is too loose to stabilise their debt ratios. We are not too worried about some of these – particularly the US – where investors do not generally seem concerned by the level, or even trajectory, of public sector debt. But Italy remains a big concern (see here), as do some larger EMs including Brazil (see here) and South Africa (see here).

Chart 2: Government Primary Balance (As a of % GDP)

Chart 3: Primary Balance (As a % of GDP) That Would Stabilise the Government Debt Ratio

Sources: Refinitiv, IMF, Capital Economics


Vicky Redwood, Senior Economic Adviser, victoria.redwood@capitaleconomics.com