Potential financial risks due to high levels of public debt and structurally higher interest rates

The International Monetary Fund (IMF) points out that high levels of global public debt, in both advanced and emerging economies, could pose risks to financial stability if more decisive fiscal measures are not taken to ensure its sustainability. According to the IMF’s estimates, public debt as a percentage of gross domestic product (GDP) has increased significantly in recent years and will continue to rise to levels of 120% in advanced economies and 80% in emerging and middle-income economies by 2028, against a backdrop of lower economic growth and higher interest rates going forward.

Key takeaways:

• Higher interest rates, higher cost of debt servicing going forward: Public debt as a percentage of gross domestic product (GDP) has increased significantly in recent years (according to the IMF, it could reach levels of 120% in advanced economies and 80% in emerging and middle-income economies by 2028) against a backdrop of very low interest rates. However, according to IMF estimates, the new normal going forward will be higher interest rates and lower economic growth, which will increase states’ financial burden. These are a few reasons why real interest rates will remain high:
  
  
  • Central banks continue to fight inflation, which will produce rate volatility for some time.
    
    
  • The normalization of central bank balance sheets (commonly referred to as quantitative tightening) may lead to an oversupply of long-term fixed income securities in the market that were previously absorbed by central bank balance sheets, implying higher interest rates for new debt issues.
    
    
  • In countries with expansionary fiscal policies and high inflation, central banks could maintain high rates to achieve their objectives.
    
    
• Bank-sovereign risk nexus: The higher the level of debt, the greater the possibility of banks’ balance sheets having more exposure to public debt, which in a scenario of financial stress could cause risks to financial stability in two ways:
  
  
  • States with more debt and higher primary deficits will have less capacity to support banks in difficulty.
    
    
  • Banks with greater exposure on their balance sheets to public debt will be impacted more by the sovereign fiscal fragility that could arise with potential negative impacts on profitability and capital.

In conclusion, according to the IMF, countries should begin a path of fiscal consolidation, and build room for maneuver while financial conditions are relatively accommodative and the labor market remains strong.