With inflation reaching multi-decade highs, and growth forecasts slowing down, the global economy is on the brink of a debt crisis. Economists and financial experts are warning of a potentially prolonged period of ‘stagflation’ not seen since the 1970s, compounded by public spending and borrowing during the COVID-19 pandemic, energy crises, risk-averse investors, and ongoing war and conflict.
While no country is immune from economic downturns and recessions, emerging markets and developing economies (EMDEs) – which face greater vulnerabilities as a result of elevated inflation, high debt levels and weak fiscal positions – are at particular risk. Reuters reports that countries such as Sri Lanka, Egypt, Ghana and Pakistan have already called on the International Monetary Fund (IMF) for debt relief and support.
What is public debt?
Public debt, also referred to as sovereign debt, government debt or federal debt, is the amount of money that a country owes to lenders – outside debtors – who may be individuals, financial institutions, international organisations, businesses, or governments of other countries. It usually only accounts for national debt – and not debt owed by different municipalities or provinces – however definitions do vary between countries.
Public debt, generally speaking, often deals with mammoth sums of money. To offer some context, the United Kingdom general government’s current public debt status, provided by the Office for National Statistics was £2.365tn at the end of the first quarter of 2022. The UK general government deficit – its net borrowing – was £15.8bn in the same quarter, equivalent to 2.6 per cent of gross domestic product (GDP).
What are the main types of public debt?
Public debt can take a variety of forms.
Internal and external debt
When a government takes a loan out with individuals, banks or financial institutions, or businesses within its own nation – in the home currency – it is referred to as internal debt. External debt, therefore, is money – in foreign currency – borrowed from international organisations or governments in other countries.
Productive and unproductive debt
Money that is borrowed for income-generating initiatives – such as developing electricity or solar energy plants – is considered ‘productive’ debt. However, there is also ‘unproductive’ debt, where loans are taken out for activities such as funding wars.
Redeemable and irredeemable debt
Redeemable debts cover loans that have maturity dates or fixed future repayment dates. In contrast, irredeemable debts are those without fixed future repayment dates where governments do not have to pay regular interests.
Voluntary and compulsory loans
Voluntary loans occur when governments issue debt securities in order to raise funds. The opposite is a compulsory loan, where taxpayers are mandated to deposit money or people are bound to compulsory contributions in other ways.
Short-term and long-term debt
Borrowing can be short-term (where sovereign loans are paid back within one year), long-term (where sovereign loans are paid back in ten years or more), or medium-term (somewhere in between).
How does public debt affect the economy?
When faced with budget deficits, governments borrow and accrue public debt in order to pay for services or in an attempt to grow their economies.
Running, building and developing countries does not come cheap. As such, governments may need to borrow money to fund infrastructure development and public welfare programmes, or funnel cash into public sector enterprises. In such instances, public debt can be used to public benefit, stimulating economies and delivering much-needed services and development.
However, according to finance specialists, The Balance, when debt reaches 77 per cent or more of gross domestic product (GDP) it begins to slow economic growth. Countries engaged in excessive borrowing – where the debt-to-GDP ratio is unsustainable – find themselves in increasingly dangerous situations where national balance sheets grow ever-more precarious. Failing to address long-term fiscal challenges weakens the economy, reduces access to capital, stymies investment, fails to produce the conditions for growth and puts nations in greater risk of economic crisis. As governments use more funds to pay off interest costs, less is available for public investment and public services – a significant factor in the UK’s crippling cuts across healthcare, benefits, and education over recent years.
Further risks associated with public debt
The International Monetary Fund list various risks encountered in sovereign debt management.
- Market risk, which involves changes in market prices and can impact interest rates, exchange rates, commodity prices and debt servicing.
- Rollover risk, which is the risk that debt will have to be rolled over at unusually high cost or cannot be rolled over at all.
- Liquidity risk, which refers to the costs or penalties faced in trying to exit a position when transaction numbers or market depth decreases, as well as liquid assets diminishing in value.
- Credit risk, which relates to non-performance by borrowings regarding loans and other financial assets, or by a counterparty on financial contracts.
- Settlement risk, which is the potential loss a government could face as a result of failing to settle.
- Operational risk, which encompasses transaction errors, inadequacies and failures in internal controls, systems and services, reputation risk, legal risk, security breaches, and natural disasters.
How can public debt be addressed?
Public debt must be adequately managed if it is to remain at sustainable levels. There are a variety of methods that national governments can explore in a bid to minimise ballooning debt, however most options involve negative impacts alongside the positives. Common interventions include:
- avoiding war and reducing military spending
- raising the retirement/pension age
- broadening the tax base to increase tax revenue
- implementing ‘debt ceilings’
- stimulating economic growth
- adjust land value tax
Explore key issues relating to public debt, monetary policy and financial sustainability
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