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Explosion in fiscal budgets raises questions over sovereign debt sustainability

"Blessed are the young, for they shall inherit the national debt."

So said Herbert Hoover, the 31st president of the United States who served in the wake of the Great Depression in 1929 until 1933. Then, as now, authorities were taking extraordinary fiscal measures to stimulate the economy as demand melted away.

When Hoover left government, politicians were concerned that U.S. public debt was up to 20% of GDP, today it is 106.2% and rising. The U.S. fiscal deficit in 2019 was already relatively high at 4.6% of GDP. With the U.S. Senate signing off on a $2 trillion fiscal package and tax returns expected to slump, Morgan Stanley forecasts the deficit to balloon to 18% of GDP in 2020. This would be double the 9% deficit in 2009 during the Great Recession. Fitch now anticipates total debt to reach 115% of GDP by the end of 2020.

The explosion in public debts around the world has already seen rating agency Fitch downgrade the U.K. to AA- from AA on March 27, noting the "commensurate and necessary policy response to contain the COVID-19 outbreak will result in a sharp rise in general government deficit and debt ratios." The U.K. has outlined a £330 billion guaranteed loan scheme to help businesses as well as tens of billions of pounds in fiscal stimulus.

US debt warning

Fitch also shot a warning to the U.S. on March 26. While acknowledging the higher potential debt tolerance of the U.S. relative to other AAA-rated sovereigns, in part due to the "financial flexibility" afforded it by having the world's reserve currency, "the prospect of permanently higher budget deficits will weigh increasingly heavily on sovereign creditworthiness."

But if investors are nervous about the ability of the U.S. to pay its bills, the bond market — the typical vehicle for investors to express their concern — suggests a sea of calm.

The U.S. 10-year Treasury was yielding just 0.66% at the close of March 30, approaching the March 9 all-time low of 0.54% and down from 1.56% on Feb. 19, when the spread of the coronavirus sent convulsions through financial markets. Yields fall as prices rise.

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"One of the legacies of this crisis will be higher debt burdens, but now is not the time to worry about this. The immediate priority is to cushion the collapse in demand," wrote Neil Shearing, chief economist at Capital Economics in a research note.

How much debt?

The G-20 group of rich nations pledged March 26 to spend $5 trillion to prop up the world economy. The fiscal policy has been supported by the heavy artillery of monetary policy. Besides slashing interest rates, numerous central banks have announced quantitative easing programs to lower the cost of debt. Morgan Stanley estimates that the total asset purchases announced by the Federal Reserve, European Central Bank, Bank of England and the Bank of Japan amount to $6.5 trillion with the Fed accounting for $4 trillion to $5 trillion alone.

Wells Fargo economists calculate that net Treasury issuance will be "a stunning" $1.4 trillion in the second quarter, excluding Fed purchases which averaged $75 billion a day in the week of March 23. For the full year, Wells Fargo expects the U.S. federal deficit to be $2.4 trillion, up from $984 billion in 2019.

But assuming the economy does begin to recover later this year, then there are questions about government's ability to pay off debt.

According to the president's budget for fiscal year 2020 — calculated before the coronavirus stimulus package — the interest due on public debt in 2020 is at $479 billion, up from $393 billion in 2019, and set to rise to $823 billion by 2029.

In its June 2019 review of the U.S. economy, the International Monetary Fund said the U.S. debt-to-GDP was already on an unsustainable path.

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S&P Global Ratings stripped the U.S. of its AAA rating in 2011 on concerns that the government would be unable to rebalance the books amid a highly partisan political environment, something it deemed necessary considering the growing debt burden. U.S. public debt jumped from 64.6% of GDP at the end of 2007 to 95.4% in 2010 as central government borrowed to support the economy during the financial crisis and its aftermath.

But in a paper for the Centre for Economic Policy Research, Nobel prize-winning economist Paul Krugman has said the example of Japan shows that these new debt levels are sustainable, and has suggested that even a debt to GDP of 200% would not be a problem for the U.S.

Japan's government debt has spiraled since its economic stagnation in the 1990s. Debt-to-GDP was already above 100% in 1996, and has swollen to 237.7%.

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Less important for governments than the size of government debt is its ability to service it.

Before the coronavirus strangled economic activity, the government anticipated net interest repayments in fiscal 2020 to total $479 billion, some 13.1% of the total government receipts. This burden has grown from 9.8% in 2018 and 11.4% in 2019, and was due to peak at 15% in 2023 before falling back. With both tax intakes set to fall and more debt being taken on, this figure is instead set to rise further even with historically low borrowing costs.

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Krugman argues that Japan's experience shows that concerns over high ratios of public debt to GDP "were misplaced" and argues that "a look at the arithmetic of debt in an era of low interest rates suggests that permanent stimulus is entirely doable."

"At this point Japan doesn’t look like a cautionary tale; it almost looks like a role model."

It is unclear if rating agencies agree. S&P Global Ratings grades Japan's foreign-currency sovereign debt at A+, six notches above speculative grade and four below the top-rated AAA, while Moody's holds Japan at the equivalent A1.

Neither S&P Global Ratings nor Moody's were unavailable for comment by the time of publication.

In a June 2019 report on the U.S. sovereign rating, S&P said that it expected the U.S. government to begin taking measures to address the fiscal challenges the U.S. was facing. "A failure to do so could lead to a negative rating action."

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.