The ominous shadow of global debt

The IMF's latest reports warn that piecemeal solutions won't suffice anymore

The clouds of a potential debt crisis are threatening to cast an ominous shadow over the global economic landscape. The International Monetary Fund’s (IMF) latest Fiscal Monitor (April 2024) has flagged grave concerns. Even four years past the Covid-19 outbreak, fiscal deficits and debts remain elevated worldwide compared to pre-pandemic projections. 

The IMF’s latest Global Debt Monitor, which tracked data until December 2022, reported total global debt (private plus public) to have risen to $235 trillion, equivalent to 238 per cent of the global gross domestic product (GDP) — a good 9 percentage point above its pre-Covid level, driven primarily by the mounting debts of economic powerhouses China and the US. Remarkably enough, China’s debt explosion, outpacing the rest of the emerging world, accounted for over half of the increase in global debt ratios since 2008 — a sobering statistic that underscores the gravity of the situation.

The April Fiscal Monitor further highlights that fiscal prudence may take a back seat in 2024, the “Great Election Year,” when 88 economies, representing more than half of the world’s population, are scheduled to hold elections. Electoral compulsions leading to populist measures and profligate spending (to woo voters) could exacerbate deficits and debts globally, compounding the looming debt crisis and jeopardising long-term economic stability.

With the global economy settling into a new normal of lower potential growth and tighter monetary policy, the debt runup seems poised to regain fresh momentum. The ramifications of excessive debt are going to be far-reaching and potentially catastrophic.

First, as interest rates remain elevated to combat lingering inflation, with the US federal funds rate now between 5.25 per cent and 5.5 per cent, its highest since 2007, the debt servicing cost will continue to spiral. Over the last decade, US interest payments have more than doubled, crossing $1 trillion in 2023, driven by a record $34 trillion debt on its account. In China, the debt-servicing burden is projected to increase by 7.8 per cent to a record 1.27 trillion yuan ($177 billion) in 2024. Such massive debt overhang risks starting a vicious cycle of financial instability by straining government finances, corporate balance sheets, and household budgets, choking off credit and investment — the lifeblood of economic growth.

Second, unsustainable debt levels will further worsen sovereign ratings in many countries and constrain governments’ ability to make productivity-enhancing public investments. For example, Moody’s rates Italy, sitting on a €2.4 trillion debt pile (144 per cent of its GDP), just one notch above junk (investment) grade with a negative outlook. The debt burden has also left little fiscal space for public investments — so much so that Prime Minister Giorgia Meloni has embarked on a massive €20 billion disinvestment plan for its national entities to avert economic stagnation.

Third, overleveraged corporations will likely face heightened bankruptcy risks as economic growth falters and borrowing costs escalate. US corporate debt has surged to nearly 80 per cent of GDP — double its level in the early 1990s. S&P Global forecasts default rates for below-investment-grade bonds to reach 4.75 per cent by the end of 2024. Such a wave of insolvencies could trigger mass layoffs, depressed consumer spending, and a severe credit crunch, throttling US economic vitality with a global cascading effect.

Fourth, at the household level, countries like Norway, Denmark and the Netherlands have witnessed household debt soar past 225 per cent of their disposable income. Such precarious household finances portend drastic consumer spending cuts amidst job losses or higher borrowing costs, thereby stifling aggregate demand.

Fifth, the debt crisis has also affected developing economies, accentuating their vulnerabilities. According to UNCTAD’s Trade and Development Report Update (April 2024), nine low- and middle-income countries (LMICs) had fallen into debt distress, with an additional 25 on the brink. In many LMICs, public external debt payments are consuming over a fifth of government revenues. A full-blown debt crisis in these vulnerable nations could reverse decades of progress on poverty, disease, education and development.

Sixth, sovereign debt crises have proven to be a tinderbox for social unrest, conflicts and geopolitical frictions, disrupting trade and investment flows. The Greek debt crisis inflamed tensions in the Eurozone, while Sri Lanka’s debt default fanned violent protests that led to a constitutional crisis. Such a breakdown of global order imposes systemic risks far beyond any single nation’s finances.

So what’s to be done? As the IMF rightly emphasises, piecemeal solutions won’t cut it anymore. We need a comprehensive, coordinated action plan to rein in the looming debt storm. For starters, governments — especially across the advanced economies — need to articulate binding multi-year fiscal consolidation road maps to restore debt sustainability over the medium term. However, as Greece’s experience showed, indiscriminate austerity may be self-defeating. Fiscal reforms should focus on boosting long-term revenue streams and target unproductive expenditures.

For corporations, deleveraging through retained earnings, asset sales, and tighter financial policies aligned with stringent risk management shall be crucial. Regulators, too, must maintain a watchful eye, ensuring banks and shadow lenders build adequate capital buffers to absorb increased corporate defaults without transmitting shocks across the financial system. For debt-distressed economies, timely and comprehensive debt restructuring is imperative. This shall require unprecedented coordination between creditors like China, multilateral lenders like the IMF and World Bank, and private sector bondholders. From maturity extensions to haircuts, all options must be pursued to restore fiscal sustainability.

Finally, the global debt binge underscores an urgent need to reform the international financial architecture. Building deeper and more liquid capital markets, harmonising cross-border bankruptcy regimes, and adequately funding multilateral safety nets could go a long way in preventing and containing future debt crises. This gathering economic storm necessitates a response commensurate with its scale — a globally coordinated, multi-stakeholder action plan accommodating national constraints while upholding debt transparency, accountability and sustainability as core tenets of the policy responses. Further inaction and complacency risk unleashing the full destructive fury of the burgeoning debt crisis. The time to act is now.

The writer is a professor at IIM Ranchi