High levels of private and public debt, along with rising interest rates, are creating uncertainty in the economic outlook.
In Ernest Hemingway’s novel *The Sun Also Rises*, a British aristocrat famously explains his bankruptcy with the phrase, “Two ways. Gradually, then suddenly.” This description could also apply to the financial challenges facing the world today. Governments and corporations accumulated massive debt during the Covid-19 pandemic, borrowing extensively to manage the crisis. Now, as central banks raise interest rates to address post-pandemic inflation, a significant portion of this debt will need refinancing at much higher costs. Governments across the globe, from Tokyo to Washington, are grappling with increased expenses for pensions and health benefits, while voters resist both benefit cuts and tax increases.
The combination of developed-economy debt and rising inflation is constricting credit for developing nations, some of which are already experiencing a wave of post-pandemic defaults. At the same time, there is a pressing need for new investment to combat climate change and adapt to its impacts.
Emre Tiftik, director of Sustainability Research at the Institute of International Finance (IIF), notes, “There is no historical precedent for the current global debt situation. We are in uncharted territory.”
To illustrate the scale of the issue: global debt has surged by $45 trillion, or 17%, since early 2020, according to the IIF. Despite a slight decline in 2022, global debt now stands at three times the size of the world economy. Emerging markets, especially China, have added nearly $25 trillion to this debt since 2019. Sovereign interest payments jumped by 20% last year to $1.4 trillion, and could potentially double by 2025 under current interest rate projections.
Rising interest rates have pushed one in seven US corporations into “zombie” status, where their debt service exceeds profits, according to the IIF. In China, corporate debt relative to GDP is nearly double that of the US and is increasing again as the economy recovers from “zero-Covid” policies. The International Monetary Fund reports that more than half of the world’s low-income countries are either in or at high risk of debt distress, with nine developing nations having already defaulted in the past three years.
The timeline for transitioning from “gradually” to “suddenly” is uncertain. James Cielinski, global head of Fixed Income at Janus Henderson Investors, acknowledges that while the idea of reaching an inflection point is plausible, it could take longer to manifest than anticipated.
The largest debt accumulators in recent years have been the US, China, and Japan—contrasting with past debt crises driven by emerging markets or consumer overleveraging, as seen in the 1980s, 1990s, and 2008 financial crisis.
While it is advantageous that the largest economies are leading this debt cycle due to their considerable resources, it also poses risks. If one of these major economies fails, the global consequences could be severe. US government debt, encompassing federal, state, and local levels, grew from 108% to 128% of GDP during the peak of the pandemic in 2020, before falling to 119% as economic growth and inflation boosted nominal GDP and tax revenues. However, this boost is diminishing.
The US federal government ran a $1.4 trillion deficit last year, or about 5.5% of GDP—comparatively better than Argentina’s 3.8% deficit. Political gridlock complicates finding solutions, as Republicans oppose tax increases and cuts to military spending, while Democrats reject reductions in pensions or healthcare. Recent debates over the national debt ceiling have had minimal long-term impact.
Despite these challenges, the risk of the US Treasury defaulting appears remote. Ray Dalio, chief investment officer of Bridgewater Associates, described the situation as a classic late-cycle debt crisis, where excessive debt and a shortage of buyers create a supply/demand imbalance. He warned that continuing on this path could lead to a difficult balancing act in the next 5-10 years.
Private Sector Resilience
In the US and many other regions outside of China, corporate debtors generally appear to be managing well despite some challenges. This relative stability is largely due to their ability to secure substantial financing during the period when interest rates were at historically low levels. According to Jack McIntyre, portfolio manager for Global Fixed Income at Brandywine Global, “Corporations are in a position similar to homeowners; they locked in favorable rates and don’t face immediate refinancing concerns.”
However, debt burdens are increasing. For instance, Bloomberg reports that interest expenses for US companies surged 22% year-over-year in the first quarter of 2023. Despite this, Richard Familetti, chief investment officer for US fixed income at SLC Management, points out that corporations entered this period with debt coverage ratios at their highest in 20 years. Defaults and downgrades are occurring at rates consistent with historical norms.
“Corporate credit risk in the USA is relatively manageable,” Familetti concludes. Another positive development is the state of household debt, which was a major factor in the global financial crisis 15 years ago. Since then, US household debt as a percentage of GDP has decreased from 98% to 75% and remains low in most countries, with notable exceptions like Australia and Canada.
Terence Chan, a senior researcher for S&P Global in Melbourne, notes that “Consumers and consumer lenders have been relatively cautious since 2008.” In contrast, China’s debt situation is quite different. While central government debt remains low, corporate debt (especially among state-owned enterprises) and debt at local and regional government levels have been rising.
Concerns are mounting about these local and regional debts, which Goldman Sachs estimates at $23 trillion. Much of this debt is held by local government financing vehicles (LGFVs), whose financial details are not transparent. Revenue from land sales to property developers, a key income source for local governments, has dwindled. The construction sector, hit hard by the pandemic and regulatory crackdowns, is struggling to recover. Michael Hirson, head of China research at 22V Research, predicts that “Property demand will not rebound to previous levels, leading to a permanent slowdown in the sector.”
The central government, which recorded a $402 billion current account surplus in 2022, has the resources to support struggling regions this year. However, it is cautious about providing open-ended financial assistance, fearing it might encourage local governments to hide debt. Hirson anticipates that Beijing might allow some LGFVs to default towards the end of this year or early next year, potentially leading to financial instability. Regional borrowers represent about 40% of China’s domestic bond market.
China could potentially increase taxes, as government revenue at all levels amounts to about 20% of GDP, compared to an OECD average of 34.1% in 2021. Currently, only 10% of Chinese citizens pay income tax, and property tax is not levied. Despite the lack of significant political opposition, Beijing seems hesitant to pursue tax increases.
This leaves the Chinese government with limited options to address the growing debt issue, though there may still be time to find a solution. “The immediate situation isn’t critical, but the next few years will be crucial,” Hirson warns.
Japan, despite participating in pandemic-era fiscal stimulus, remains notable for its high government debt, exceeding 260% of GDP. However, Japan’s economic environment is unique, with persistently low interest rates and a domestic market dominated by bond buyers.
In Japan, investor concerns are more focused on stagnant corporate cash reserves rather than excessive debt. A global debt crisis is unlikely to originate in Japan.
The eurozone, having weathered a severe crisis during the Greek debt crisis a decade ago, is currently in a more stable position. Government debt levels are lower than in 2014, and banks are tightly regulated, avoiding the turmoil seen in some US regional institutions.
The European Union’s 2020 proposal for joint bonds totaling €806.9 billion for pandemic recovery, and discussions about additional bonds for energy transition, reflect a unified approach that reduces the likelihood of a national debt crisis in high-debt EU members like Italy. According to Cielinski, “The EU’s unity helps mitigate the risk of individual country crises. Future issues are likely to be eurozone-wide challenges.”
Big Challenges for Economies
Low-income countries face severe financial strain and cannot afford to delay addressing their debt crises. “Debt vulnerabilities are concentrated in these countries, many of which have lost access to international debt markets,” observes Tiftik from the Institute of International Finance (IIF).
Most emerging markets, excluding China, lacked the resources for significant new spending to counter the impacts of COVID-19. The pandemic drastically reduced revenue through declines in exports and tourism, while rising post-pandemic interest rates have increased borrowing costs, if they could borrow at all. Additionally, the US dollar’s appreciation of over 30% in the past decade has exacerbated these challenges.
While defaults have been limited to smaller economies such as Sri Lanka, Ecuador, Zambia, and Ghana (with Russia, Ukraine, and Belarus facing unique issues due to conflict and sanctions), larger nations like Nigeria, Egypt, and Pakistan are now facing heightened debt concerns. Pakistan, in particular, is dealing with a precarious fiscal situation compounded by political instability, natural disasters, and ongoing conflicts between its former Prime Minister Imran Khan and the military.
Climate change is expected to intensify financial pressures in developing countries. Ulrich Volz, director of the Centre for Sustainable Finance at the University of London, points out that developed nations pledged $100 billion annually by 2020 to help developing countries manage climate impacts. However, this promise has not been met, partly due to rising domestic debts in wealthier countries.
In the private sector, while corporate debt is largely manageable, there are risks in specific areas such as commercial real estate. The sector remains weak as remote work and changes in consumer behavior have decreased demand for office space. For instance, office occupancy rates in New York were around 50% of pre-pandemic levels in May, and London’s occupancy was about 26.5% as of March, down from 60-80% before the pandemic.
This situation poses a risk to credit markets, particularly in the US, where troubled regional banks hold significant commercial real estate and construction loans. A recent study by Trepp highlights that about a quarter of US banks with assets below $50 billion exceed regulatory limits for such loans. This follows high-profile failures of banks like Silicon Valley Bank, Signature Bank, and First Republic Bank.
Federal Deposit Insurance Corporation (FDIC) Chair Martin Gruenberg has warned of challenges for commercial real estate portfolios if office space demand remains weak. A pullback by regulated banks might drive more market share to private credit, an industry that has grown significantly since 2008 and now exceeds $2 trillion globally. Tiftik and colleagues from the IIF expect continued pressure on US regional banks to drive further expansion in private debt markets.
With over $2 trillion in opaque, illiquid financial commitments, S&P’s Chan raises concerns about the potential instability in private credit markets: “This sector could be vulnerable if there’s a rush to liquidate.”
In this environment, major governments borrowing substantial amounts at high or “normalized” interest rates could lead to tighter financial conditions for others. Private sector CFOs may need to focus more on maintaining financial stability rather than expansion. “My advice to CFOs is to maintain higher cash reserves and consider investing in safe assets like US Treasury securities,” suggests Richard Familetti of SLC Management.
Capital discipline could be beneficial, such as scaling back investments in unproductive areas like ghost cities in China or speculative tech ventures in Silicon Valley. However, addressing global challenges requires more substantial investments to mitigate climate risks, estimated at an additional $3.5 trillion per year through 2050, according to a January 2022 McKinsey report. China also needs to allocate resources for promises related to pensions, healthcare, education, and infrastructure.
A broad “Great Reset” of attitudes from policymakers and citizens is necessary, as Chan and colleagues argue. “Avoiding a severe debt crisis will require deploying new debt productively, writing down unproductive debt, reducing overconsumption, and restructuring failing enterprises,” they note. These measures may not be popular, and finding solutions will be challenging.
