Public debts are high and rising. And the world worries. Academic economists worry that the “long-term trend in debt accumulation seems inconsistent with [these] theories of optimal government debt policies” (Yared 2019). Portfolio managers and financial regulators worry about the shrinking universe of safe assets, excessive risk-taking, and the corresponding threats to financial stability. International financial institutions worry that if history is any guide, current debt levels likely carry the seeds of future trouble involving some painful combination of sovereign default, high inflation, and financial collapse (e.g. Sandleris 2016).
Assessing debt sustainability is hard
While it is instantly clear that knowing when public debt is too high is vital for economists and practitioners alike, the answer is frustratingly hard to find. In fact, it boils down to a mere judgement informed by multiple methodologies (e.g. D’Erasmo et al. 2016). Basic stylised facts speak loudly of the challenge: how can we imagine an operational framework suggesting that Japan can sustain debt levels above 200% of GDP without any pressure on sovereign yields, while Ukraine defaulted on a debt stock equivalent to 30% of its GDP?
In a contribution to a recent volume on sovereign debt (Debrun et al. 2019), we conclude that building a holistic framework that is able to tell confidently whether a country’s public debt is sustainable or not amounts to mission impossible. The reason is simply that the future is unknowable. Indeed, public debt sustainability is conceptually joined at birth with government’s solvency, that is, its ability to honour all current and future obligations. As such, sustainability is a purely forward-looking notion, and assessing it amounts to reading tea leaves.
As if the lack of concrete meaning (and simple indicators) was not hard enough, debt sustainability assessments face at least three other challenges.
First, for governments, servicing the debt is a strategic choice that includes tricky political considerations. Thus, market beliefs about the terms of the underlying cost-benefit analysis determine the credibility of a government’s commitment to meet its obligations. Such beliefs are intrinsically volatile and can lead perfectly solvent governments to default, or insolvent ones to thrive well beyond the point of no return. Second, the constellation of potential shocks hitting the government’s balance sheet is broad and extremely difficult to model (Clements et al. 2016). Third, not all debts are born equal as the currency composition, maturity structure, and ownership of the debt (domestic investors base versus fickle foreign investors) determine exposure to rollover risks.
Our detailed review of the economic principles and statistical methods forming today’s leading practice in debt sustainability assessments suggests adopting an eclectic approach tailored to users’ needs and purpose. The resulting frameworks will nevertheless build on common elements, including (i) medium-to-long term projections of debt ratios, (ii) measures of uncertainty around the projections, (iii) indicators of potential liquidity stress, and (iv) discussions of other country-specific risks or mitigating factors. Overall, three key principles should guide any methodological endeavour aimed at gauging public debt sustainability: relevance, simplicity, and transparency.
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Since assessing sustainability is about understanding what is likely to shape future debt dynamics, having a good grasp of fiscal policy behaviour is key and collecting information about the main drivers of a country’s primary budget balance is paramount. Evidence that a government has historically neglected to behave in a way consistent with stable public debt dynamics – for example, by failing to systematically improve the primary balance in response to rising debt – should raise concerns. By contrast, a stable and positive relationship between debt and the primary balance provides a strong signal of underlying commitment to long-term solvency.
The economic and financial environment of the country also matters a great deal. In particular, the joint dynamics of interest rates and economic growth are paramount to understand how a given pattern of policy behaviour translates into certain debt paths. For instance, countries relying on financial repression have been able to maintain interest rates consistently below growth rates, allowing them to avoid explosive debt-to-GDP ratios while running primary deficits on a routine basis (e.g. Escolano et al. 2011, Wyplosz 2019). By contrast, countries facing borrowing costs well in excess of their growth rates have had to maintain high primary surpluses for a long time before curbing their public debt trajectory (see Debrun 2005 for a case study of Turkey).
Last but not least, because the future is uncertain, any debt sustainability assessment must give a sense of the risks likely to affect public debt dynamics over the medium term. The main difficulty lies in the great variety of shocks affecting the public sector balance sheets and ultimately reflected in shocks to public debt. Beyond high-frequency oscillations in interest and growth rates, usually well captured by ‘fan charts’, some countries may be more exposed than others to large, idiosyncratic shocks such as natural disasters or bailing out large state-owned enterprises – best captured by tailored stress tests.
Of course, many other considerations matter and their relative importance in the debt sustainability assessment will depend on the country. For instance, liquidity risks are likely to be irrelevant when looking at a country issuing a reserve currency (like the US) or counting on a very large and stable domestic investors’ base (like Japan), but essential in countries which depend heavily on external borrowing in foreign currency. The risk of default or inflating away the real value of the debt is also highly dependent on those country-specific circumstances.
… but keep it simple and transparent despite growing challenges
A clear and present danger facing economists and practitioners involved in debt sustainability assessments is to be overwhelmed by the number, fuzziness, and complexity of relevant considerations. The resulting urge to be as holistic, non-linear, and stochastic as possible should nevertheless be resisted. The importance of public debt sustainability in the eyes of stakeholders with limited public financial literacy (taxpayers, voters, and small investors) gives considerable value to the simplicity and transparency of sustainability assessments. For instance, fan charts may well appeal to experts but come across as black boxes to non-specialists, who could even perceive a false sense of actually knowing the most likely outcomes, while underlying models remain uncertain. Practitioners would be well advised to keep in mind the poor noise-to-signal ratio that could emanate from intractably complex and opaque frameworks.
Clearly, the current environment of ultra-low interest rates and seemingly insatiable demand for safe assets complicates the trade-off between relevance and simplicity/transparency. In particular, the persistence of conditions in which interest rates remain below growth rates makes government Ponzi schemes consistent with stable or declining debt ratios. As analysed in Barrett (2018), this challenges the relevance of conventional methods to pin down limits beyond which debt dynamics could turn explosive (Ostry et al. 2011), and forces economists and practitioners to think harder about plausible scenarios likely to bring back normal conditions. Open questions about central bank credibility and thinly veiled threats to their independence could also limit their capacity to stabilise sovereign debt markets and to preclude self-fulfilling prophecies. No doubt that the premium on communicating as clearly as possible about the risks to public debt sustainability is high and rising.
Authors’ note: The views in this column are those of the authors and do not necessarily represent the views of the National Bank of Belgium or the IMF, its Executive Board, or IMF management.
Barrett, P (2018), “Interest-Growth Differentials and Debt Limits in Advanced Economies,” IMF Working Paper No. 18/82.
Debrun, X (2005), “Sustaining High Primary Surpluses: Lessons from an Empirical Model of Fiscal Policy in Emerging Market Economies”, chapter VII in Turkey at the Crossroads—From Crisis resolution to EU Accession, IMF Occasional Paper, No 242, pp. 45-48.
Debrun, X, J D Ostry, T Willems and C Wyplosz, (2019), “Public Debt Sustainability,” in A Abbas, A Pienkowski, and K Rogoff (eds), Sovereign Debt: A Guide for Economists and Practitioners, Oxford University Press.
D’Erasmo, P, E Mendoza, and J Zhang (2016), "What is a Sustainable Public Debt?," in Handbook of Macroeconomics, Elsevier.
Escolano, J, A Shabunina, and J Woo (2011), “The Puzzle of Persistently Negative Interest-Growth Differentials: Financial repression or Income Catch-Up?” IMF Working Paper No. 11/260.
Ostry, J D, A R Ghosh, J I Kim, and M Qureshi (2011), “Fiscal Space”, IMF Staff Position Note N° 10/11.
Sandleris, G (2016), “The Costs of Sovereign Defaults: Theory and Empirical Evidence,” Economia 16(2): 1-27.
Wyplosz, C (2019), “Olivier in Wonderland,” VoxEU.org, June 17.
Yared, P (2019), “Rising Government Debt: Causes and Solutions for a Decades-Old Trend,” Journal of Economic Perspectives 33(2): pp. 115-140.