Two of the key questions that are begging answer from the
central bankers infusing trillions of dollars in fresh liquidity in the global
financial system and the governments borrowing incessantly to further their
populist agenda, is what will be the impact of this debt burden on the
potential economic growth? and How the perpetually slow growth will impact the
demography, i.e., whether the world will follow the demographic trends of Japan
and grow old? (see How
will this tiger ride end?)
As per the World Bank report titled Global Waves of Debt -
Causes and Consequences, "Amid record high global debt, low interest
rates and subpar growth have led to an intense debate on whether the recent
rapid increase in debt is reason for concern. Some argue that countries,
especially those that issue reserve currencies, should take advantage of low
interest rates to borrow more to finance priority expenditures. Others caution
that high debt weighs on long-term growth, by increasing the risk of crises,
limiting the scope for countercyclical fiscal stimulus, and dampening private
investment."
The report further highlights that, "Although the focus of
this debate has been mainly on advanced economies, similar issues are also
faced by EMDEs. Many of these economies have also borrowed heavily and, in many
cases, hard-won reductions in public debt ratios prior to the global financial
crisis have largely been reversed over the past decade. The tradeoffs EMDEs
face are actually even starker, in light of their histories of severe debt
crises even at lower levels of debt than in advanced economies and their more
pressing spending needs to achieve development goals and improve living
standards."
The importance of public debt in growth economics can hardly be
overemphasized. Government investment in physical and human capital provides an
important foundation for stronger economic growth over the long term. It helps
in attaining the ideal goal of full employment and optimum capacity utilization
on sustainable terms.
It is important to note that despite substantial progress over
the past two decades in many areas, several Sustainable Development Goals
(SDGs) remain well out of reach. As per the World Bank estimates, to meet the
SDGs, EMDEs have large investment needs: low- and middle-income countries face
aggregate investment needs of $1.5–$2.7 trillion per year—equivalent to 4.5–8.2
percent of annual GDP— between 2015 and 2030 to meet infrastructure-related
SDGs, depending on the effectiveness of this investment, accompanying policy
reforms, and the degree of ambition in meeting the SDGs. Higher debt level for
emerging and underdeveloped economies is necessary in most cases.
Besides, temporary debt accumulation can also play an important
role in helping to minimize and reverse short-term economic downturns. During
recessions, borrowing financed government spending or tax cuts can provide
stimulus to support demand and activity.
However, it is important to do an intensive cost benefit
analysis of every dollar in new debt. The cost of debt is not only the interest
payable on such debt; but also the impact of the debt on the future growth
potential and changes in socio-economic structures.
During the post-crisis period, the cost of government borrowing
in terms of rate of interest has been historically low, for both advanced
economies and EMDEs. Further, demographic shifts and slowing productivity
growth are expected to contribute to a further secular decline in real interest
rates in advanced economies, continuing a multi-year trend. However, if a
sudden increase in global borrowing costs occurs; the sustainability of high
debt in some countries will be tested. A failure in this test could bring
disastrous consequences.
As per the World Bank, "Debt sustainability has
deteriorated since the global financial crisis both in advanced economies and
in EMDEs. In advanced economies, debt-reducing fiscal positions (i.e., positive
sustainability gaps) in 2007 turned into debt-increasing fiscal positions
(i.e., negative sustainability gaps) from 2008. Subsequently, sustainability
gaps narrowed and, in 2017, returned to debt-reducing positions. In EMDEs,
debt-reducing positions in 2007 turned into debt-increasing positions in 2015.
In commodity-exporting EMDEs, this deterioration partly
reflected the sharp growth slowdown that came in the wake of the steep slide in
commodity prices. Subsequent recoveries in commodity prices and economic
activity helped improve debt sustainability in these economies and, by 2018,
fiscal positions in commodity exporters had become debt reducing. In
commodity-importing EMDEs, fiscal positions have remained weak as a result of
fiscal stimulus implemented during the global financial crisis, chronic primary
deficits, and, in some cases, anemic post-crisis growth, leading to
debt-increasing fiscal positions in 2018.
High debt constrains governments’ ability to respond to
downturns with countercyclical fiscal policy. This was the case during the
global financial crisis: fiscal stimulus during 2008-09 was considerably
smaller in countries with high government debt than in those with low debt.
This is one of the reasons why weak fiscal positions tend to be associated with
deeper and longer recessions, a situation that worsens if the private sector
also falls into distress and its debt migrates to government balance sheets as
the government attempts to rescue private enterprises. Reducing the
effectiveness of fiscal policy. High government debt tends to render
expansionary fiscal policy less effective. Specifically, high government debt
can reduce the size of fiscal multipliers through two channels
With higher debt typically comes higher debt service. Spending
on higher debt service needs to be financed through some combination of
increased borrowing, increased taxes, and reduced government spending. Spending
cuts may even include spending on critical government functions such as social
safety nets or growth-enhancing public investment. Separately, high and rising
government debt may raise long-term interest rates and yield spreads. High debt
could also create uncertainty about macroeconomic and policy prospects,
including risks that the government may need to resort to distortionary
taxation to rein in debt and deficits (IMF 2018a; Kumar and Woo 2010). Higher
interest rates and uncertainty would tend to crowd out productivity-enhancing
private investment and weigh on output growth.
As per the available empirical evidence, a return to monetary
policy normalization in advanced economies could raise borrowing costs (Ruch
2019). If there was a rapid increase in policy interest rates, as happened in
the first global wave of debt accumulation, it could be accompanied by large
currency depreciations in EMDEs that would sharply increase debt service
burdens for foreign currency-denominated debt (Arteta et al. 2016). It would
also be likely to trigger a turn in investor sentiment that would especially
affect those EMDEs with large foreign participation in local bond markets,
which in some economies now exceeds 30 percent of government bonds. Although
the normalization of monetary policy in USA and EU is not visible on horizon,
occurrence of this even could spell disaster for many emerging economies.
It is pertinent to note that during crisis it does not take much
for the private debt to become public debt. Large private sector losses,
including losses threatening bank solvency, and the materialization of
contingent liabilities, including those of state-owned enterprises, can lead
governments to provide substantial financial support. We have seen glimpses of
this phenomenon in India in past 10 years.
During the current wave of debt, potential growth in EMDEs has
also declined, because of slower productivity growth as well as demographic change.
Productivity growth has declined as investment growth has slowed, gains from
factor reallocation have faded (including the migration of labor from
agriculture to manufacturing and services), and growth in global value chains
has moderated. Slower investment growth has tempered capital accumulation.
Demographic trends have become less favorable to growth, since the share of
working age populations in EMDEs peaked around 2010. In case of India it is
expected to peak in this decade. Burgeoning debt could therefore a major issue
for these economies.
(Most of this write up is reproduced from the Word Bank Report
titled Global Waves of Debt - Causes and Consequence. The copyrights are
acknowledged.)
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