Sovereign Debt

Investors should expect high volatility and a selloff in US stocks over the short run due to the higher-than-usual risk of technical default. Investors should seek shelter in defensive sectors and large cap stocks. Long-dated Treasuries will see yields fall due to the overall macro and geopolitical context even though short-dated Treasuries will continue to suffer from policy uncertainty.

Cyclically-speaking, the risk of global indebtedness does not appear to be acute. There are several pockets of sizeable private sector debt risk, and it is possible that the next US/global recession will cause a more pronounced economic downturn in some of these countries. Over the next one-to-three years, these risks are likely to be idiosyncratic. With the possible exception of France’s corporate sector, private sector debt risks appear to be manageable in the US, euro area, and China, the main drivers of global economic activity. However, over the longer-term, there are several problems with global indebtedness that will eventually “come home to roost.” US government debt is now excessive, and we expect meaningful net interest pressure for the US government in three-to-four years, even if the US does not experience elevated structural inflation. In China, the government’s strong desire to avoid aggravating structural imbalances will lead to the limited and finely balanced use of fiscal and monetary policy to boost growth, which is not good news for China-related financial assets. On balance, our conclusions are generally consistent with a structural bear market in the US dollar that is likely to begin after the next US recession. It also speaks to the possible structural outperformance of euro area stocks within a global equity portfolio, and possibly a continuation of the structural bull market in gold – which would benefit mightily from the development of any fiscal risk premia in US assets. The global financial crisis of 2008-2009, as well as the subpar economic recovery that followed, demonstrated to global investors the threat posed by elevated private sector and government debt. There has been a substantial improvement in the risk of indebtedness in some sectors of some countries over the past 15 years, but the risks of excessive indebtedness have increased in other areas of the global economy. In this special report, we check in on the indebtedness risk of a list of major economies using the BIS’ credit to the nonfinancial sector database and examine whether these risks exist primarily in the household, non-financial corporate, or government sectors. We contextualize the indebtedness data from the BIS into a risk score using several risk factors (by sector and by country), based on how elevated a given sector’s risk factor is relative not only to its own history but also the history of other countries. The sector risk scores are presented on pages 24 to 29, and we present a synthesis of our analysis below.1 We conclude that, while there are limited cyclical implications of recent trends in global indebtedness, there are several problems that will eventually “come home to roost” – particularly in the US and China. This would be consistent with a structural bear market in the dollar and a long-term uptrend in the price of gold, and could point to structural euro area outperformance within a global equity portfolio. A Global Indebtedness Report Card Table II-1 presents the aggregate risk score for each country by sector that we examined in our report. Several themes are evident from Table II-1 and the tables shown on pages 24 to 29. Table II-1A Summary Of Our Debt Risk Scores By Country/Region And Sector May 2023 May 2023 Shifting Household Sector Indebtedness Risk Chart II-1Shifting Household Sector Indebtedness Shifting Household Sector Indebtedness Shifting Household Sector Indebtedness The risk of household sector indebtedness has rotated from countries like the US and Spain to several other countries/regions, including Hong Kong SAR, Australia, Canada, and Sweden (Chart II-1). These are relatively smaller countries/regions and thus theoretically pose less of a risk to global financial stability than excessive household sector debt in the US and select euro area economies did in 2008. Mainland China remains one important wildcard for investors to watch. Ostensibly, the risk of China’s household sector indebtedness is only moderate according to our risk score methodology, given that its household debt-to-GDP ratio is lower than in many other countries. However, it has grown at a very significant rate over the past decade. In addition, household disposable income is lower as a share of GDP in China than in most advanced economies, and China’s housing sector has experienced a significant shock over the past two years. The fact that interest rates in China are likely to remain comparatively low versus the pace of economic growth, and that China’s property market is stabilizing, suggest that a major debt crisis in China’s household sector is unlikely over the coming year. The recent property market crisis, however, serves as a reminder of the potential structural vulnerability posed by Chinese household sector debt, which would almost certainly cause a global recession were a major deleveraging event to occur. Chart II-2Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Some Surprises From The Trend In Corporate Debt Some countries with elevated nonfinancial corporate sector debt risk scores will not be surprising to investors. Chart II-2 highlights that Hong Kong's corporate sector indebtedness is massive and that mainland China's nonfinancial corporate sector debt risk is also very elevated. Mainland China's corporate sector debt risk is concentrated in state-owned enterprises, reflecting the significant quasi-fiscal spending (mainly in the form of infrastructure investment) that has occurred over the past decade in support of economic stability. However, Sweden and France also have very elevated nonfinancial corporate sector debt risk, whose corporate sector scores closely mirror their risk scores from the shadow banking sector. “Shadow credit” references credit that is not provided by domestic banks. A rise in shadow credit appears to be the source of the increase in nonfinancial corporate sector indebtedness in both Sweden and France. Shadow credit poses a risk to financial stability because credit availability from nonbank entities could tighten rapidly in a crisis; it thus points to potentially outsized economic weakness in Sweden and France in a bad economic scenario. Based on the IMF’s stress test results, we continue to regard Sweden’s nonfinancial private sector as one of the riskiest in the developed world. Real Long-Term Risks From US Government Indebtedness Investor concerns about the rise in US government debt have prevailed for over a decade following the surge in the debt-to-GDP ratio that occurred following the global financial crisis. However, with interest rates having fallen to extremely low levels during the last economic expansion, the debt servicing burden of US government debt was minimal. The COVID-19 pandemic changed that reality in two ways. First, the fiscal response to the pandemic resulted in another surge in the debt-to-GDP ratio. Second, the surge in inflation that occurred in the latter half of the pandemic has caused both short-term interest rates and expectations for future interest rates to rise. We expect interest rates to fall meaningfully during the next US recession, so a US government debt crisis is not imminent. However, we doubt that the fed funds rate over the coming decade will be as low as it has been over the past ten years. Higher average interest rates point to net interest costs exceeding their early-1990s levels later this decade (Chart II-3), which could cause financial market participants to force fiscal adjustment via a crisis. Chart II-3The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US is not the only country with elevated government debt risks. China, the euro area (excluding Germany) and the UK also rank highly according to our aggregate risk score methodology, as does Canada – although this reflects our use of gross rather than net debt to facilitate international comparability (see page 27 for details). The recent mini fiscal crisis in the UK is a preview of what may occur in the US and other countries on a grander scale in three-to-four years, given our view that the next US recession is likely to be mild and that the neutral rate of interest in the US and euro area is not as low as many investors believed prior to the pandemic. China’s relatively elevated government debt risk score reflects a significant rise in local rather than central government debt over the past decade, but that too carries risks for China’s economy given the way Chinese economic policy is carried out. Admittedly, these risks are much more likely to pertain to the risk of economic stagnation rather than an acute crisis. The Presence of Fiscal Space As A Buffer Against Private Sector Indebtedness In several of the countries identified with excessive indebtedness, the debt is concentrated in either the private nonfinancial or the government sector. For example, in the case of Sweden, its very concerning private sector debt load is somewhat offset by a very low government debt risk score, suggesting the presence of fiscal space in Sweden that could allow its government to respond to any private sector deleveraging event. However, in a few countries/regions, debt appears to be elevated in both the private and public sector: chiefly in Hong Kong, mainland China, and France (Chart II-4). France is a core member of the euro area; a corporate sector debt crisis in France would have a meaningful impact on European economic activity, but China’s very sizeable debt load is obviously more concerning given the importance of China as one of the three pillars of the global economy. Chart II-4Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Investment Conclusions There are no real cyclical investment conclusions to be drawn from our analysis of global indebtedness. There are several pockets of sizeable private sector debt risk, and it is possible that the next US/global recession will cause a more pronounced economic downturn in some of these countries. However, with the possible exception of France’s corporate sector, private sector debt risks appear to be manageable in the US, euro area, and China, the main drivers of global economic activity. China’s nonfinancial corporate sector is indeed extremely leveraged, but much of this debt resides on the balance sheet of state-owned enterprises and thus is unlikely to pose a cyclical economic risk due to government support – especially given recent incremental easing in China. Tight monetary policy in the US and euro area is a much more proximate risk to the business cycle and, as described in Section I of our report, we expect a recession in the US to begin at some point over the coming six-to-twelve months. However, our analysis of global indebtedness highlights several problems that will eventually “come home to roost”. US government debt is now excessive. The likely future path for interest rates implies meaningful net interest pressure on the government in three-to-four years, even if the US does not experience elevated structural inflation. And in China, the government’s strong desire to avoid aggravating structural imbalances will lead to the limited and finely balanced use of fiscal and monetary policy to boost growth. As we noted in last month’s report,2 that is not good news for China-related financial assets, as it implies that Chinese policymakers will remain reactive and that China will become a more insular economy with even broader state influence or control. The Xi administration’s paradigm shift implies a very different China than many investors became accustomed to between 2008 and 2014, and one that is far less likely to stimulate global economic growth. In short, this is not, and likely will not be, the China that you have been hoping for. On balance, these conclusions are generally consistent with a structural bear market in the US dollar that is likely to begin following the next US recession. It also speaks to the possible structural outperformance of euro area stocks within a global equity portfolio, and possibly a continuation of a structural bull market in gold – which would benefit mightily from the development of any fiscal risk premia in US assets. Finally, once the next US administration is in place and a new high in the servicing costs of US government debt is within sight, investors should structurally monitor the spread between 10- and 30-year US Treasury yields for signs of an abnormally steep curve. An aggressive shift into short-duration positions will be warranted in response to any true signs of a budding fiscal crisis in the US. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Private Nonfinancial Sector The countries/regions most at risk from elevated private non-financial sector debt are Hong Kong SAR, Sweden, mainland China, France, Canada, and the Netherlands (Table II-2). Across all of the metrics shown in Table II-2 that measure the risk of indebtedness, Hong Kong consistently ranks as the riskiest market. This is particularly true based on debt service measures, which show an extremely large amount of income “lost” to repaying debt. Unlike the case of mainland China, Hong Kong’s sharp rise in private sector indebtedness over the past two decades (and especially since 2009) has not occurred due to government efforts to stabilize economic activity. Hong Kong’s pegged exchange rate effectively imports US monetary policy, which has been extraordinarily easy since the global financial crisis – particularly for an economy that did not suffer the same shock to household balance sheets that occurred in the US. The source of the risk from Sweden’s indebtedness is somewhat different than is the case in Hong Kong. Sweden’s private sector debt-to-GDP level is meaningfully below Hong Kong’s, although that is mainly indicative of how extreme the latter is. More importantly, the pace of leveraging in Sweden’s private sector indebtedness has been somewhat slower than in Hong Kong and indeed a few other countries/regions (such as Japan, France, and mainland China); it ranks third after Canada based on the first of our two debt service proxies. However, based on our second DSR that uses a measure of equilibrium interest rates, Sweden appears to be much riskier. Table II-2High Private Nonfinancial Sector Debt Risk In Hong Kong SAR, Sweden, China, France, And Canada May 2023 May 2023 The Household Sector The countries/regions most at risk from elevated household sector debt are Hong Kong SAR, Australia, Canada, Sweden, and the Netherlands (Table II-3). Relative to Hong Kong’s total private sector debt, the household sector is not the dominant contributor. When compared across countries/regions, however, Hong Kong’s household sector debt-to-GDP ratio is among the most extreme. Australia, Canada, and the Netherlands rank worse than Hong Kong in terms of household sector debt-to-GDP, but both economies have recently seen meaningfully slower household debt growth than has occurred in Hong Kong. Aside from the Netherlands, euro area economies rank quite low on the list of household sector indebtedness risk and nontrivially lower than in the UK. The risk of indebtedness posed by the household sector in mainland China may be understated in Table II-3. This is because China’s household disposable income is smaller as a share of GDP than most of the other countries/regions shown in the table, which causes artificially lower debt ratios when scaled relative to GDP. Relative to developed market economies, Chinese interest rates are meaningfully below the prevailing pace of income or GDP growth, so we still suspect that China’s household sector debt service ratio is not extremely high. Investors should acknowledge, however, that the risk posed by China’s household sector leverage is probably larger than conventional debt-to-GDP measures would indicate. Table II-3High Household Debt Risk In Hong Kong SAR, Australia, Canada, Sweden, And The Netherlands May 2023 May 2023 The Nonfinancial Corporate Sector The countries/regions most at risk from elevated nonfinancial corporate sector debt are Hong Kong SAR, Sweden, France, mainland China, and Canada (Table II-4). Unlike in mainland China, where most nonfinancial corporate sector debt is held on the balance sheets of state-owned enterprises, Hong Kong’s corporate debt does not have the same defacto state backing and is enormously concentrated in the real estate and financial sectors. Hong Kong’s real estate sector does enjoy significant structural policy support from the government. It is also true that the region has been highly indebted for some time. But Table II-4 highlights that Hong Kong’s nonfinancial corporate sector is massively leveraged and is thus vulnerable to a permanent rise in US policy rates and/or a property market crisis in the region. Commercial Real Estate (CRE) debt constitutes a large portion of Sweden’s corporate debt. IMF stress tests of Sweden’s CRE sector show that the median interest rate coverage would drop below one in a severe scenario, resulting in 75% of firms with debt-at-risk.3 We continue to regard Sweden’s nonfinancial private sector as one of the riskiest in the developed world. France ranks surprisingly high on the list of nonfinancial corporate sector indebtedness, the result of an M&A boom in the years prior to the COVID-19 pandemic. Our debt service ratio calculations suggest that the servicing burden of this debt may be lower than the BIS’ DSR would suggest, but it is still elevated even based on our measures. This suggests that the French nonfinancial corporate sector should be closely watched over the coming year, especially if the ECB were to keep its policy rate in restrictive territory. Table II-4High Corporate Sector Debt Risk In Hong Kong SAR, Sweden, France, China, And Canada May 2023 May 2023 The Government Sector The countries/regions most at risk from elevated government sector debt based on the BIS’ gross government debt data are Italy, the US, Canada, the UK, and Spain (Table II-5). If Canada were removed from the list, China would be the fifth most vulnerable country according to our methodology. We show gross debt-to-GDP in Table II-5 because of the lack of reliable net debt measures for China, but gross debt measures have many drawbacks. Canada is an example, as its gross debt-to-GDP ratio suffers from two international comparability problems. First, Canadian general government debt statistics include sizeable accounts payable (20% of GDP). In addition, the Canadian government holds significant financial assets; Canada’s net debt is very low compared to other developed economies. The gross/net debt issue also impacts the government indebtedness risk score for Japan, although Japan’s net government debt is still extremely elevated (160% of GDP). Very elevated debt levels in Italy, especially in net debt terms, underscore why the effective neutral rate of interest is likely lower in the euro area than would be the case if the euro area was one political and economic entity. The extraordinary US fiscal response to the COVID-19 pandemic underscores that the US will likely face a fiscal reckoning in the latter half of the decade as net interest costs eventually exceed their early-1990 levels. It is impossible to come up with a precise estimate of when the US will face market pressure for fiscal reform, but our best guess is that it will occur at the tail end of the next US administration. Table II-5High Government Debt Risk In Italy, The US, The UK, And Spain May 2023 May 2023 The Total Nonfinancial Sector (Private Plus Government) The countries/regions most at risk from total nonfinancial sector debt (private plus government) are Hong Kong SAR, mainland China, Sweden, Canada, and France (Table II-6). As noted above, Canada’s rank in Table II-6 is likely overstated due to the country’s much lower net debt ratio, although it would still rank relatively high given very elevated private nonfinancial sector debt. We agree that private sector debt is typically more of an economic risk than public sector debt. It is important to examine total debt, however, as it reflects the combined risk of a private sector deleveraging event that the government of that country will struggle to respond to because of a lack of fiscal space. The fact that Hong Kong and mainland China top this list underscores the risk of long-term economic stagnation in the region, and partially explains why the Xi administration is focused on improving China’s financial resiliency. Sweden’s government debt risk score is extremely low, but the country’s very elevated private nonfinancial sector debt is large enough for total nonfinancial sector debt to show up at an elevated level (similar to Canada). France’s comparatively high levels of government debt, even when measured in net debt terms, underscore the economic risks to the country were its highly leveraged nonfinancial corporate sector to experience a crisis following a period of meaningfully tight euro area monetary policy. Table II-6High Total Debt Risk In Hong Kong SAR, China, Sweden, Canada, And France May 2023 May 2023 Non-Domestic Bank Credit To The Private Nonfinancial Sector The countries/regions most at risk from excessive non-domestic bank credit (“shadow banking”) are Sweden, Hong Kong SAR, France, Japan, and Canada (Table II-7). The risk posed by shadow credit is that debt provided by non-bank entities is very rarely amortized, meaning that it needs to be periodically rolled over. The other risk is that lending standards or credit availability from these entities is more discretionary than is the case for banks and thus could tighten rapidly during a crisis. Combined with non-amortized loans/bonds that need to be rolled over, high levels of credit provided by the “shadow banking” sector could result in larger or more frequent credit “crunches.” Generally speaking, the list of countries with high shadow banking risk matches those that show up as high risk for the private nonfinancial sector. Japan is an exception. Global investors should be attuned to any potential credit availability issues that arise in Japan should JGB yields eventually rise, potentially in response to the end of the BOJ’s yield curve control policy. Table II-7High Shadow Bank Risk In Sweden, Hong Kong SAR, France, Japan, And Canada May 2023 May 2023 Appendix: Debt Risk Measures Our debt risk score tables present five measures of debt risk for three individual sectors and two aggregate sectors over fourteen countries/regions. The five sectors include: Households Nonfinancial corporations Government The private nonfinancial sector (aggregate of households and nonfinancial corporations) The total nonfinancial sector (aggregate of households, nonfinancial corporations, and the government) We also examine the private nonfinancial sector focusing on debt that is not provided by domestic banks (“shadow banking”). Our methodology scales each measure of debt vulnerability for each country across the matrix of histories of all fourteen[1] countries/regions for that debt vulnerability measure using a percentile rank. In that way, we compare each country’s measure to a range of country histories, rather than only its own history. We scale these measures as scores from 0 (best / lest vulnerable) to 10 (worst / most vulnerable) and present the most recent observations in the tables included in this report. Our five measures include: The BIS[2] Credit-to-GDP Ratio: Ratio of total credit provided to the sector to GDP The BIS Debt Service Ratio: Ratio of debt payment estimate to gross disposable income (GDI). This measure is not available for the government sector, the overall nonfinancial sector, as well as for nonfinancial corporations for China and Hong Kong SAR. The BCA Credit-to-GDP Gap: Measure of Credit-to-GDP relative to its 10-year moving average The BCA Debt Service Ratio (Proxy 1): Ratio of debt payment estimate 1 to gross domestic product (GDP) The BCA Debt Service Ratio (Proxy 2): Ratio of debt payment estimate 2 to gross domestic product (GDP) We also include an Aggregate Debt Risk Score, which aggregates the scores of all debt vulnerability measures available by sector for each country using an equal weight approach. Our BCA Debt Service Ratios are calculated in the following manner: We estimate principal payment schedules of 18 years for households and of 10 years for nonfinancial corporations. We then estimate a principal payment component of the total debt payment by dividing the stock of debt by the debt maturity. We do not consider a principal payment in cases where debt is exclusively not amortized, such as government debt. We then compute the measure of debt interest payment by multiplying the overall stock of debt by an interest rate proxy. For our DSR proxy 1, we use the 10-year government bond yield as a measure of effective interest rate plus a spread of 1.75% for household sector debt and 1% for nonfinancial corporate sector debt. One exception applies to Hong Kong SAR, where we use US 10-year Treasury yields given Hong Kong’s pegged exchange rate. For our DSR proxy 2, we use an estimate of the equilibrium interest rate instead of 10-year government bond yields with the same household/corporate sector spread estimates. Our estimate considers the median 10-year nominal GDP growth rate as the equilibrium interest rate, with exceptions for euro area members, Hong Kong SAR, and mainland China. For euro area economies, we use euro area GDP rather than the individual country GDPs due to the commonality of monetary policy. For Hong Kong SAR we use US GDP rather than Hong Kong GDP given its pegged exchange rate and its importation of US monetary policy. For mainland China we use half of the estimated equilibrium interest rate, given that China has consistently maintained a large gap between domestic interest rates and the prevailing rate of nominal GDP growth. We then add the interest payment estimate to the principal payment estimate (when applicable) to obtain total debt payment. We then express these debt payments as a percent of GDP. Gabriel Di Lullo Research Analyst   Footnotes 1 Please see the appendix on pages 30 and 31 for a description of our debt score methodology. 2 Please see The Bank Credit Analyst "April 2023," dated March 30, 2023, available at bca.bcaresearch.com 3 Sweden’s Corporate Vulnerabilities: A Focus on Commercial Real Estate, IMF Working Paper, Selected Issues Paper No. 2023/024, March 21, 2023

An important annual event is when long-time client Mr. X visits BCA strategists at the end of each year to talk about the economic and financial outlook and a write-up of the discussion is published as our Annual Outlook report. Recently, BCA’s former Chief Economist Martin Barnes had the pleasure of a chance encounter with Mr. X at an airport lounge, and this report is an edited transcript of their conversation.

Bullish equity sentiment may persist in the second quarter on the Fed’s pause, but tight monetary policy, financial instability, elevated recession odds, extreme US polarization and policy uncertainty, and still-high geopolitical risk should encourage investors to maintain a defensive position for the coming 12 months.

Biden’s State of the Union address will mostly be blocked by a gridlocked Congress. The one point of agreement, big spending, spells trouble over the long run, even if a technical default is avoided this fall.

The narrative that the US can tolerate much higher interest rates, compared to the rest of the world has helped the dollar in 2022. In this report, we examine the sustainability of this thesis, from our holistic assessment of global growth indicators.

Dear Client, Section II of this month’s Bank Credit Analyst report is a guest piece written by Martin Barnes, which we are making available to all clients. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for government debt and the possibility of an eventual crisis. I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Highlights Recent developments in the UK highlight the power of financial markets to reimpose discipline over wayward fiscal policies. However, the bond vigilantes remain notably absent in the US. The strong dollar and lack of a fiscal premium in Treasury yields indicates investor complacency about the US fiscal position. However, the long-run trajectory of US government debt and deficits is unsustainable. It will take market pressures to force an inevitable change in US fiscal policies. This is very unlikely to occur in the coming year but there are good odds of it happening within five years. The ‘solution’ to a market-induced US debt crisis will involve a mix of higher inflation, financial repression, increased taxes and spending restraint. Feature I, however, place economy among the first and most important of virtues, and public sector debt as the greatest of the dangers to be feared. Thomas Jefferson I used to think that if there was reincarnation, I wanted to come back as the president or the pope. But now I want to be the bond market: you can intimidate everybody. James Carville, adviser to former US President Bill Clinton. If something cannot go on forever, then it will stop. Herb Stein, renowned US economist A remarkable feature of the economic and financial landscape during the past two decades has been the markets’ calm acceptance of an explosion in government debt throughout the developed world. In many countries, public sector debt-to-GDP ratios have hit peacetime records as a share of GDP yet until recently, bond yields remained at historically low levels. What happened to the bond vigilantes that so impressed James Carville? With the benefit of hindsight, we can look back and explain why soaring public deficits and debt levels did not cause major disruptions. Central bank purchases of government bonds reduced the supply available for private investors at a time when the demand for ‘safe’ assets was very strong. Meanwhile, private sector savings were abundant and, again until recently, inflation was quiescent. But that is the past, what about the future? There is little prospect of a significant reduction in public-sector debt burdens in the major developed economies in the coming few years. Uninspiring economic growth implies ongoing pressures for fiscal stimulus, aging populations will underpin growth in pensions and health care spending and geopolitical tensions will support increased defense spending. The rise in inflation gives some help to revenues, but higher interest rates provide an offset. The long-standing concern about large public sector deficits is that they threaten to push up interest rates, crowd out private sector investment and lower potential growth. And along the way, there is the threat of financial volatility and crises. I could fill several pages with quotes and analyses from eminent economists during the past two decades predicting impending economic and financial doom unless government finances were brought under control. Not surprisingly, the failure of any crises to emerge has discredited such gloomy forecasts, fostering complacency about the issue. Recent developments in the UK warn of what can happen. The announcement of an aggressive program of tax cuts and increased borrowing rattled investors, leading to a sharp drop in the exchange rate and rise in bond yields. As a result, the government was quickly forced to abruptly change policy, abandoning its planned tax cuts. The economic and financial fallout also led to a change in political leadership with the new government warning that tax increases and spending curbs will be needed to restore fiscal stability. The market vigilantes clearly are alive and well in the UK, even if they are missing in action in the US. The US dollar’s status as the world’s premier reserve currency gives the country protection from the wrath of investors that is not always available to others. However, this is a mixed blessing because it gives policymakers more rope with which to hang themselves. The trend in US public debt burdens is unsustainable, and as Herb Stein noted, this means something will change. The key questions relate to how and when this will occur. The Disturbing Path Of Government Debt Chart II-1The Historical Sweep Of Debt The Historical Sweep of Debt The Historical Sweep of Debt Historically, major spikes in government deficits and debt generally occurred only in wartime (Chart II-1). However, the past 15 years have witnessed two extraordinary surges in public sector indebtedness – firstly in response to the 2007-09 economic and financial meltdown and secondly because of the Covid pandemic. In both episodes, tax revenues declined, and governments boosted spending to shore up economic activity. In the major advanced economies, net government debt as a percentage of GDP jumped by around 20% from pre-crisis levels in each of the periods (Chart II-2). And when indebtedness ratchets higher, it is difficult to reverse. Despite concerns about crowding out, it is hard to find an empirical relationship between the size of budget deficits and either interest rates or the growth in private investment. For example, deficits rise when the economy is weak and this is when interest rates tend to fall, not rise. Even if the analysis uses cyclically-adjusted budget balances (i.e. removing the impact of swings in the economy) it is hard to find a good relationship. But that does not mean rising deficits and debt do not matter. At some point they impact market confidence about how policy may be forced to change in the future. Uncontrolled fiscal finances ultimately will lead to financial turbulence. Public sector dynamics are a function of two key variables: the difference between the average interest rate on the debt and nominal GDP growth, and the primary budget balance (i.e. the budget balance before interest payments). The debt-to-GDP ratio will decline if the primary budget is at least in balance and the borrowing rate is below the GDP growth rate. Conversely, it will soar if there is a primary deficit and the borrowing rate is above the economic growth rate. Currently, most countries face primary deficits (Chart II-3) and interest rates are not likely to be far enough below growth to stop debt-to-GDP ratios from rising in the years ahead. Chart II-2Economic Crises Cause Spikes In Debt Economic Crises Cause Spikes in Debt Economic Crises Cause Spikes in Debt Chart II-3Lingering Primary Deficits Lingering Primary Deficits Lingering Primary Deficits   Chart II-4The Long-Run US Debt Outlook The Long-Run US Debt Outlook The Long-Run US Debt Outlook The picture in the US is particularly disturbing given its outsized role in global markets. According to the Congressional Budget Office (CBO), absent any policy changes, the federal budget deficit will average 5% of GDP over the next decade, with the primary deficit averaging 2.5% of GDP. As a result, the ratio of federal debt to GDP will be close to 110% of GDP in ten years’ time. Importantly, these projections do not allow for any recessions and use optimistic assumptions for interest rates (averages of 2.4% and 3.5% over the next decade for 3-month rates and 10-year Treasury yields, respectively). The uptrend in indebtedness continues over the longer run, taking the federal debt-GDP ratio to 140% by 2042 and 185% by 2052 (Chart II-4). Of course, this won’t happen because markets will force a change long before we get to that point. Signposts For A Debt Crisis It is impossible to predict what level of indebtedness will trigger a market reaction because much will depend on the circumstances at the time. Nevertheless, several signs can help to warn when a country is approaching a debt wall. Warnings signs include the following: Surging debt interest payments An increased dependance on issuing short-term or foreign currency debt A limited ability to raise taxes to reduce budget deficits Rising risk premia on government yields and/or a plunging exchange rate Surging Debt Interest Payments: Failure to service the debt means falling into default – something inconceivable for any developed country. Thus, debt interest payments must be made and if they rise sharply then they can crowd out other forms of government spending, creating political and/or economic problems. Canada faced this problem in the early 1990s with federal debt interest payments exceeding 30% of total revenues and more than 25% of total spending. This forced the government into a major fiscal retrenchment, eventually leading to several years of budget surpluses. In 2021, interest costs were a mere 6.5% of federal revenues. The past 15 years have been a period of exceptionally low interest rates, dramatically reducing borrowing costs, even as debt levels have climbed. In the US, federal interest payments represented only 8.7% of revenues in fiscal 2021. This was less than half the level of the early 1990s even though the ratio of outstanding debt to revenues doubled over the period (Chart II-5). While interest rates have risen this year, it will take time for this to feed through into a significant increase in the average cost of debt financing. The fact that the Fed holds more than 20% of outstanding Treasuries also helps because the interest payments on these securities are returned to the Treasury. In sum, there are few signs of an imminent problem in the US on this score. Increasing dependence of short-term or foreign currency debt: If investors are worried about a country’s fiscal stability then they will become increasingly reluctant to take on duration risk. This should show up in increased risk premia on longer-term debt, forcing governments to rely more on short-term financing. Once again, there are few signs of problems in the US. The spread between 30- and 10-year Treasuries has fallen sharply in the past year and there has not been any notable change in the average maturity of debt (Chart II-6). It is surprising that the Treasury did not use the opportunity of historically low yields to lock in more longer-term debt. Chart II-5Low Interest Rates Have Cut Debt Servicing Costs Low Interest Rates Have Cut Debt Servicing Costs Low Interest Rates Have Cut Debt Servicing Costs Chart II-6No Evidence Of A Fiscal Risk Premium No Evidence of a Fiscal Risk Premium No Evidence of a Fiscal Risk Premium   A financial revolt against economic policies typically shows up in the foreign exchange market as investors abandon the perceived risky currency. Collapsing currencies put upward pressure on inflation and interest rates and typically force a change in government policy. And countries that depend on overseas buyers of their debt may be forced to start issuing debt in foreign currencies, creating a vicious cycle as a weak currency then adds to debt servicing costs. A rise in the issuance of US dollar-denominated debt was another sign that Canada was facing problems in the 1990s. US dollar-denominated issues as a percent of foreign purchases of Canadian public sector bonds rose from 6% in 1983-88 to 45% in 1988-93. The US is in a very favorable position because the dollar’s reserve currency status means that the US can borrow freely in its own currency. Even when the dollar suffered long-run declines such as in 1985 to 1995 and 2002 to 2011, the US never needed to issue foreign-currency debt. The last time the US issued non-dollar debt was in 1978 when it issued bonds denominated in Deutschemarks and Swiss Francs in an effort to prop up the dollar (the so-called Carter bonds). Without the dollar’s reserve status, the US would be in a very different position because it is, by far, the world’s largest external debtor to the tune of $18 trillion (79% of GDP) at the end of 2021. The combination of high ratios of public debt-to-GDP and external debt-to-GDP normally would be toxic for a currency and the US is at an extreme in both measures compared with other major countries (Chart II-7). The US position compares to countries such as Germany, Canada and Switzerland that are net international creditors and have relatively low government debt-to-GDP ratios. There is a particularly interesting contrast with Japan as it has extremely high government debt but is a massive net external creditor. The fact that Japan does not rely on foreigners to buy its debt helps to explain why bond yields have stayed low in the face of huge budget deficits. And it helps that the Bank of Japan owns close to 50% of outstanding government bonds. Since 2016, the Bank of Japan has pledged to keep 10-year bond yields within 25 basis points of zero, but yields remained low even before that policy. It seems odd for the world’s largest international debtor nation to have the major reserve currency, but there has been no major competition from other countries. Given the economic problems faced by Europe, Japan and China, no change is in prospect any time soon. Room for tax hikes: A return to fiscal discipline can come from increased taxes, lower spending, or a mixture of both. Lowering the path of spending is politically challenging, especially given that in most countries, aging populations mean that non-discretionary spending (e.g. pensions and health care) accounts for a rising share of the total. Meanwhile, if tax burdens are already high, then further increases could be self-defeating via weaker economic growth and thus revenues. Not surprisingly, structural budget deficits rise more easily than they fall. Throughout much of the developed world, overall tax burdens are at historically high levels (Chart II-8). The UK experience highlights the challenges: the government used the record level of tax burdens as the case for cutting taxes, even in the face of high deficits and debt. But there was strong opposition to any attempt to finance lower taxes with real cuts to social programs. As noted earlier, bond vigilantes did not play along with the UK government’s plans. Chart II-7External And Government Debt Ratios November 2022 November 2022 Chart II-8The US Is A Low Tax Country The US is a Low Tax Country The US is a Low Tax Country   The US is in a different situation. Overall tax burdens (total general government receipts as a percent of GDP) are not at historically high levels and are by far the lowest of any industrial country, except for Ireland. While there is strong political resistance to higher taxes in the US, this is a viable route to pursue should market pressures force action. The long-term solution may be to introduce a federal sales tax.1 Options to reduce federal spending are limited given that non-discretionary spending and interest payments account for more than 70% of total outlays, a share that will continue to rise. The Changing Pattern Of Treasury Ownership Where will market pressures for US fiscal restraint come from? A long-standing concern has been that it will come from overseas – perhaps a decision by China to dump its Treasuries as a deliberate political act. This was never a very realistic possibility as it would represent an aggressive act of economic warfare, leading to serious retaliation via sanctions and curbs on Chinese exports. Nevertheless, it is reasonable to assume that, as with smaller more open economies, foreign investors will sell Treasuries and the dollar if they expect major economic and financial instability in the US. Chart II-9Ownership Of US Federal Debt Ownership of US Federal Debt Ownership of US Federal Debt The potential impact of foreign selling was greater in the past because overseas investors have accounted for a shrinking share of outstanding federal debt. The peak was in 2008-16 when the share fluctuated in the 40% to 44% range. It has since dropped below 30% (Chart II-9). Between 2002 and 2008, foreign investors absorbed two-thirds of Treasury issuance, with the two largest holders Japan and China accounting for 8.5% and 10% respectively of total outstanding debt by the end of the period. By the middle of this year, Japan’s share was down to 4.7% while China’s was 3.7%. Of course, changes occur at the margin, and it may not need much foreign selling of Treasuries to trigger panic among domestic investors. At that point, the Fed would likely step in. The launch of the Fed’s quantitative easing in 2008 represented the start of a new era of central bank intervention in the markets.2 The Fed holds more than 20% of outstanding Treasury debt and although it wants to further reduce its holdings, there is little doubt that it would resume purchases in the event of a market panic. The Bank of England recently did just that when the UK bond market went into freefall in response to the government’s reckless fiscal announcements. The Debt End Game Chart II-10Beware Of Budget Forecasts Beware of Budget Forecasts Beware of Budget Forecasts A frequently-asked question is “how will the debt ever be paid off”. The answer is that it will not get paid off because the only way to do this is to run budget surpluses, a remote possibility for the foreseeable future. The US did run federal budget surpluses for four years between fiscal 1998 and 2001 and the CBO’s January 2001 baseline projections showed the federal debt (then at $3 trillion) being almost entirely paid off within ten years. This prompted then Fed Chairman Alan Greenspan to worry about the technical challenges of conducting monetary policy in a world without government debt. Of course, things did not pan out as expected with Treasury debt reaching $11 trillion in fiscal 2011 rather than disappearing. The trend in Federal debt versus the CBOs baseline projections makes for a dismal picture and most of the divergences can be attributed to policy actions rather than economic forecasting errors (Chart II-10). Unfortunately, it is hard to imagine how the federal budget could be returned to surplus given the high and growing burden of non-discretionary spending. The solution is to make the debt easier to live with and this can be done in a few ways. Most importantly, the debt-to-GDP ratio can be reduced by boosting the growth in the denominator – nominal GDP. Ideally, this would happen via faster real growth but that seems unlikely given the demographic outlook and the lackluster trend in productivity. So it will have to occur via inflation. Reducing debt burdens by inflating nominal GDP growth will require the cooperation of the Fed. Otherwise, higher interest rates would make the fiscal situation even worse by slowing the economy and boosting debt servicing costs. The Fed’s current tightening stance should not be taken as a sign that it would never tolerate some increase in inflation. As we wrote a few months ago, inflation is set to fall over the coming year, but this will be a temporary respite.3 It will prove extremely difficult to return to sustained inflation near 2% over the medium term and a new base of 3% to 4% is likely. Another way to ease the debt problem will be via financial repression. This means keeping interest rates below ‘normal’ levels (one of the reasons to expect higher inflation) and having regulatory rules requiring financial institutions to hold high levels of government debt for supposedly prudential reasons. And finally, we will have the Fed as the ultimate backstop, stepping in if private and overseas investors cease to be buyers of Treasury debt. Finally, there will be some measures to reduce structural deficits. Taxes will increase, and actions taken to reduce the trajectory of non-discretionary spending. For example, there is scope for savings in health care spending by negotiating better prices for drugs. While it will prove near impossible to return to surpluses, it should be possible to reduce deficits from current levels. However, no politicians will impose fiscal austerity willingly and it will thus require a market crisis to force action. The bond vigilantes will have to reemerge from the shadows. Conclusions Public finance is a kind of Ponzi scheme where the proceeds of new debt issuance are used to pay existing investors. As long as new debt can be issued at reasonable yields, the show can go on. Problems emerge when investors take fright at the path of government finances and demand ever-increasing yields to compensate for perceived risks. As with all Ponzi schemes, it falls apart when new buyers fail to emerge. Proponents of Modern Monetary Theory (MMT) argued that public deficits and debt do not matter because they can be financed by central banks. However, even MMT advocates accept that this can only persist for as long as inflation stays under control. The past year’s rise in inflation has taken the wind out the sails of the MMT movement and there is very little support for the view in the economic and financial community. Chart II-11What Debt Problem? What Debt Problem? What Debt Problem? Clearly, the US is not facing an immediate problem, despite the worrying trajectory of public deficits and debt. For example, the dollar’s trade-weighted index is at a new all-time high, up 40% in the past 12 years (Chart II-11). Higher inflation and a tightening in monetary policy have pushed up bond yields, but there is no sense of a fiscal-induced investor revolt. The near-term outlook for the economy is gloomy with high odds of a recession in the coming year. That will help ease inflation pressures and bring an end to Fed rate hikes. Against that backdrop, Treasury yields will eventually reverse some of their recent rise and bond vigilantes will remain out of sight. But that will not last. Remember: what cannot go on, will stop! We should not expect politicians or voters to willingly seek fiscal austerity. For politicians, raising taxes and cutting spending is not a vote-winning proposition. And while voters may pay lip service to the idea that governments should live within their means, few people want higher taxes or the kind of cuts in spending that would make a difference. This means that financial markets have to be the ultimate disciplinarian on profligate governments. It would be nice to put a date on when markets eventually will revolt against fiscal excesses, but any attempt would be pure speculation. I am quite confident it will not be in the next 12 months but would put a 75% probability it will be within the next five years. At that point, debt-servicing costs could be at new highs. This would make it a problem for the next administration. What has happened in the UK in terms of fiscal policy and market reactions is a good indicator of what the US ultimately will face. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com   Footnotes 1    The US is the only industrial country that does not have a federal sales tax. 2    The Bank of Japan embarked on quantitative easing in 2001, but it was alone in doing so at that time. 3    Please see The Bank Credit Analyst “Inflation Whipsaw Ahead,” dated June 30, 2022, available at bca.bcaresearch.com

Is the US in a wage-price inflation spiral that could lead to more aggressive Fed rate hikes? Is it time to buy UK Gilts after a wild month of volatility? We answer "no" to both questions, as we discuss in this week’s report.

In this report, we assess that sterling likely bottomed below 1.04. We expect volatility in the currency to remain in place but are buyers below current levels. On balance, there is a tug of war between irresponsible fiscal policy and the pound as a global reserve currency. This will create a buy-in opportunity for investors who missed the latest dip.