Rising global debt levels and financial repression

Economies around the world are now faced with the highest global debt level seen in the last half a century. The pandemic induced recession alone led to the highest single year surge in global debt  since 1970. According to the Institute of International Finance (IIF), global debt rose to a new record high of nearly US$300 trillion in the second quarter of this year. This was a rise of nearly US$20 trillion in six months' time from US$281 trillion at the end of 2020.

Even before the pandemic, the global economy experienced an unprecedented surge in debt accumulation that started in 2010. The rapid increase in debt levels has the potential to turn into a financial crisis. Also, the costs of debt accumulation include interest payments and the possibility of debt distress as well as the possible crowding out of private sector investment.

After reaching all time high in the second quarter this year, global debt declined slightly to US$296 trillion in the third quarter this year, but all in developed economies. In contrast, emerging market economies debt hit a all time high of US$92.5 trillion, up by UDS$5.7 trillion in the first nine months of this year.

The word's debt to GDP ratio rose to 356 per cent by the end 2020, then declined to 253 per cent in the third quarter this year. This compares with 226 in per cent in 2019 and what now seems a modest 193 per cent of global GDP in 2007 before the global financial crisis (GFC) of 2007-08. Developing world debt topped 250 per cent of GDP by the middle of this year.

Government, private, domestic and external debt remain very high both in developed and developing economies. Public debt in emerging market economies rose by 18.5 per cent this year relative to the same period last year., while developed economies experienced much lower rise only by 3.6 per cent.

Furthermore, while interest payments in developed economies have been trending downward in recent years, exactly the opposite has been happening to developing economies. Therefore, over the next half a decade or so  spending on interest payments is poised to rise in developing economies while it falls for developed economies. This means  there will be less and less money available for education, health care and other social spendings in developing countries. 

As long as debt problem remains more pressing in developing economies than in developed economies, the result will in an unbalanced global economic recovery. Under such circumstances, the post-pandemic world faces the prospect of further rising income inequality between developed and developing countries.

Also, there is a growing fear that developing economies are not yet out of the woods. Budget deficits in these countries are likely to remain high, thus leading to further accumulation of debt. In October this year, the International Monetary Fund (IMF) sounded a broader warning that output in developing economies is expected to remain below 5.5 per cent  of the pre-pandemic forecasts even in 2024 resulting in what the IMF describes as "a larger setback to improvements in their living standards".

As debt has soared to unprecedented levels worldwide, governments have justified emergency spending to build field hospitals, emergency aid to businesses and unemployed people and to buy vaccines that in normal times would have been unthinkable. In fact, high levels of debt in many countries including the US is well beyond what economists have described as untenable in the past.

According to the World Bank (WB) more than 100 million people have been thrown back into extreme poverty since the start of the pandemic. One can only imagine what the number would be without emergency debt funded measures to counter the effects of the pandemic.

Almost all of the public debt incurred in 2020 and early 2021 was to deal with the effects of the pandemic. Now post-pandemic economic environment is largely characterised by a generalised expansion of public safety net expenditures mostly funded by debt financing causing the debt-to-GDP ratio to rise. 

The IMF estimates that at least seven countries are now in debt distress while almost 30 countries face a high risk of debt distress. Many are now forced to spend a third to half of government revenue to service debt.

Public debt levels in many advanced economies such as in Southern Europe, the US and Japan have reached peace time record highs, but it is in developing countries where the possibility of debt distress is rising. Policy makers in developing countries need to brace themselves to face such a situation when financial markets turn less benign in developing economies. Therefore, higher levels of public debt imply more state intervention in the economy and higher taxes in the future with cuts in public expenditures.

As austerity measures along with rising tax rates will lead to more economic distress for the general population and high levels of debt are considered a drag on growth, many economists are discussing about resorting to financial repression as a way out of the debt trap and low growth.

Financial repression is a term that refers to policies that artificially raise demand for government bonds to lower the borrowing costs for governments or more precisely, governments channel funds from the private sector to themselves as a form of debt reduction.

The overall policy actions such as interest rate caps among other measures result in the government  being able to borrow at extremely low interest rates, obtaining low-cost funds for government expenditures. Financial repression, in fact, represents a quasi-fiscal operation, where some groups are effectively taxed to finance public expenditures.

Financial repression in a broader context is an umbrella term referring to measures such as direct lending to the government, caps on interest rates, credit rationing, regulation of capital movement between countries, reserve requirements and a closer association between the government and banks. All these measures force savers and banks to  provide cheap funding to the government and its affiliated businesses.

In addition, if the central bank adds a dose of inflation such that bond yields turn negative in real terms, the value of government debt is reduced, even can be liquidated. Debt reduction by means of inflation is politically easier to get by with tax increases and spending cuts.

China, for example, has successfully used low administered nominal interest rates combined with inflation to provide cheap funding for state owned enterprises - a policy mix that is complemented by high official reserve requirement and capital controls. China has been able to maintain strong macroeconomic performance in presence of repressive financial policies. But that is not the case with countries like Argentina, Brazil and many other developing countries who have been resorting to financial repression.

High levels of public debt always require very low interest rates to keep debt levels low. Therefore, while low interest rates reduce the government's burden of repayment but lower return to bond holders below the rate that otherwise would prevail.

The government could also restrict international capital movement aimed at blocking alternative investment opportunities available to investors.  However, equities are not directly affected by financial repression.

Financial repression effectively lowers the real returns to government debt holders, therefore helps reduce the debt-to-GDP ratios. Financial repression has been generally associated with inflation. In fact, the two often have gone hand in hand  to create effective low real return on financial assets. But it must be noted that it is possible to have financial repression without inflation and inflation without financial repression.

Theoretical arguments for using financial repression generally rest on  market failures and information asymmetry. The GFC of 2007-08 rekindled the debate on the role of government in preventing and correcting imbalances that could weaken financial stability. But the surge in public debt in the wake of the crisis has brought to the fore the debate on the use of financial repression as a solution to reduce the debt burden.

The recent experiments in negative interest rates and quantitative easing (QE)  are clearly intended to write down debt. In fact, some suggested that the QE policy has made financial engineering much more enriching than industrial engineering. Debt monetisation has always led to inflation.

This buying of bonds helps, in turn, to keep interest rates low and potentially encourages inflationary pressures to rise. All these eventually culminate in a quicker reduction of public debt than would have been otherwise.

But it is also to be noted that inflation has drawbacks as a strategy to reduce debt. Inflation is typically accompanied by exchange rate depreciation, thus raising foreign currency denominated debt levels. Also, if high debt  levels are the result of persistent budget deficits, a bout of inflation can not give a lasting solution to the debt problem.

It is  generally suggested that financial repression reduces the probability of a debt crisis. Joseph Stiglitz attributes the rising financial risks to financial market liberalisation in developing countries. He also adds that perhaps developing countries are more able to manage money supply and financial stability under repressive financial policies.

But when the policy of financial repression was attempted after the GFC, debt levels continued rising. Both in the US and the Eurozone, short-term interest rates were kept low to negative. In the US, the government and corporations took advantage of easy money to get into more debt and now the pandemic has further accelerated the process. America's public debt has reached its post-WWII high now.

Financial repression has a long history. This has been used by both developed and developing countries, since the end of WWII. When the same policy was attempted in the wake of the GFC, debt levels continued to rise.

Now in the wake of the Covid-19 pandemic, it is widely anticipated  that financial repression will be resorted to for a long time. For some developing countries, push may soon become shove, and that will make  resorting to financial repression very tempting. But this new bout of financial repression will in all probability be accompanied by significantly higher inflation. Rising inflationary pressures will retard economic growth, thus financial repression will end up in stagflation.

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