In times of ultra-low interest rates, the issue of high government debt was pushed somewhat into the background. However, following the sharp hikes in key interest rates since the beginning of 2022, the cost of debt has risen sharply. This is all the more significant because government spending exploded, especially during the pandemic. For example, over the past two years in the United States, federal government debt increased by about a third to more than USD 31 trillion, reaching 117 % of gross domestic product.
Development of government debt (national level only) in the United States, China and the euro area as a percentage of GDP
Source: raw data by Bank for International Settlements (BIS), illustration by hpo forecasting
The high level of public debt in all major economic regions is increasingly becoming a problem and threatens to drag down the economy in both the short and long term.
In the short term, the greatest risk of economic dislocation is in the United States. In the United States, the federal government’s debt ceiling is set by law and currently stands at USD 31.4 trillion. This limit has been reached in the interim and default can only be prevented with sophisticated liquidity management and tapping of reserves. In Congress, the Democrats need the consent of at least part of the Republicans to raise the debt ceiling. In exchange for their concession, however, the Republicans are demanding massive cost reductions in the Democrats’ pet projects in the areas of climate and social security. That, in turn, is unacceptable to the Democrats. If the two parties cannot reach an agreement in the coming weeks, the U.S. government will be threatened with insolvency in June. This has happened repeatedly before (most recently before the pandemic during Donald Trump’s presidency), and it has always happened without too much economic collateral damage because the parties eventually reached an agreement.
Unlike in the past, however, the U.S. economy is in much more fragile shape today, and many economists expect a mild recession in the course of the year anyway. The banking system has been suffering stress for months. Misjudgments by the parties in the negotiation poker could have disastrous consequences in this environment, warned Treasury Secretary Janet Yellen in early May. Core inflation remains well above 5 % in Europe and the USA. The fight against inflation so far has been relatively easy because central banks have been able to raise key interest rates in a strong economic environment. However, there is still a long way to go to achieve price stability, and if the economy cools down as expected, the pressure on central banks to take their foot off the brake pedal will increase.
As key interest rates rise, so do the costs of servicing public debt. The European Central Bank (ECB) has only been able to implement its interest rate hikes since last summer thanks to the simultaneous introduction of a new instrument. This allows it to buy government bonds of heavily indebted euro states on a large scale. It prevented the risk premiums for highly indebted countries from rising sharply. Without this instrument, the current key interest rate increases would hardly have been possible without a simultaneous euro crisis. The consideration for the over-indebted European countries hinders the ECB in its fight against inflation.
In China, too, debt has risen very sharply, particularly since the financial crisis, especially that of the regional governments. These were urged to invest heavily in infrastructure in order to achieve the ambitious growth targets. According to reports in the business magazines Caixin and The Economist, Guizhou province is close to insolvency, and other provinces are in a similar situation. The American financial theorist Michael Pettis sees the reason for this in the fact that China has the world’s highest investment share of GDP, at 42 % to 44 %. Globally, this share is around 25 %, and in mature economies it is around 15 to 20 % of GDP. Even for emerging economies in the middle of a growth phase, 35 % is a very high figure.
The consequence is that in China today, the economic costs of infrastructure investments are higher than their overall economic benefits. In his extremely readable essay “Can China grow more than 2 to 3 % in the long term?” of April 21, 2023 in the business magazine The Market/NZZ, Pettis convincingly argues that the exploding debt in the country can only be stopped by rebalancing the economy. Or, to put it another way, consumption must increase massively at the expense of infrastructure spending.
If the crushing overweighting of infrastructure spending remains, debt will continue to rise rapidly and massively, and this in a rapidly aging society. Such rebalancing processes, which always involve high adjustment costs, have been experienced by all mature economies throughout history. Depending on how fast the adjustment succeeds, a severe recession or a prolonged period of low economic growth is the side effect.
The first signs of this process are already visible in China with the smoldering real estate crisis. If this development continues, China will face years of low economic growth, and even a recession cannot be ruled out. Companies that are heavily dependent on investments would have to suffer in this scenario. As the share of consumption in GDP must grow significantly in this rebalancing, opportunities are most likely to arise in China for manufacturers of consumer goods and consumer-related sectors.