How to tame the debt monster

Christian Kopf


An article by Christian Kopf

Head of Fixed-Income Fund Management and 
member of the Union Investment Committee (UIC)

The first step in gaining the trust of the capital markets is to effectively bring the level of debt under control. This requires persistently low interest rates.

Christian Kopf

The German government is planning to take on new debt amounting to €314 billion in 2020 and 2021 in order to soften the impact of the coronavirus pandemic. This amount is not far off the total volume of new loans taken on by the government in the two decades leading up to the crisis. In a report to the budgetary committee of the Bundestag in November 2020, the German Supreme Audit Institution described the amount of these emergency loans as “inappropriately high” and expressed its concern that Germany’s finances were not sufficiently sustainable and significant efforts would be required to put them back on an even keel. Almost simultaneously, the new Chief Economist of the International Monetary Fund (IMF) Gita Gopinath urged countries like Germany to not wind down their economic stimulus packages too soon.

But which is the right course of action? Will government debt in industrialised countries continue to grow until it eventually reaches a point at which it can no longer be serviced? And are countries at risk of defaulting, as was the case with Greece in 2012?

According to the IMF’s forecasts, government debt will rise significantly due to the combination of the economic collapse and the growing budget deficits in many countries. By the end of 2021, the IMF predicts that the government debt of industrialised countries will have increased by 20 per cent of gross domestic product (GDP) on average. The US government is likely to take out particularly large loans and its debt ratio is forecast to reach 134 per cent of GDP in 2021, which is 25 per cent higher than before the outbreak of coronavirus. New debt in Europe will be lower in comparison, with government debt rising by ‘only’ 16 per cent to 100 per cent of GDP on average. But some eurozone countries, such as Italy and Greece, have notoriously high levels of government debt.

Four factors will determine whether the debt ratio can be brought under control: the rate of growth of GDP, inflation, capital market rates and the government’s budgetary management.

Most governments are not even close to frugal management of their budgets. If the IMF is right with its forecasts, there will still be almost no countries with a budget surplus before interest payments in two years’ time. Even Germany’s budget before the servicing of debt (known as the primary balance) is likely to show a small deficit.

Industrialised countries will also hold out little hope of high economic growth rates that can reduce the debt burden, because they do not have the right conditions in place to fuel such growth due to their ageing populations and already very high productivity levels. Moreover, central banks have been unsuccessfully trying to stimulate inflation for years.

The good news, however, is that unlike 20 years ago, we no longer need high growth rates to tame the monster of growing government debt because capital market rates have fallen significantly. The interest rates that industrialised countries have to pay on their government debt currently stand at around 1.2 per cent. Next year, the German government is likely to only be paying an average of just 0.6 per cent on the total volume of Bunds in circulation.

With such low market interest rates, most countries will only be required – despite the sharp increase in debt ratios – to make small savings in order to stop their debt levels from rising further. This can be seen from our analysis of the sustainability of countries’ debt. Almost all industrialised countries have a sustainability gap in their government debt and will have to adjust their budgets to prevent a dramatic increase. But because interest rates are so low, most countries only need to make savings of less than 4 per cent of GDP – and just 1 per cent of GDP in Germany’s case – in order to stabilise their debt levels. This should be feasible, particularly if tax revenue rises and social welfare spending falls of its own accord as the economy recovers in the wake of the pandemic.

However, many countries face bigger challenges, including Australia, the United Kingdom and Canada. They need to make savings of 5 to 8 per cent of GDP, which is unlikely to be possible without drastic cuts. If the IMF’s forecasts prove half-way right, Greece and Portugal should very soon restart repaying their debts, as their governments are spending very frugally, and should report a neutral primary balance as early as next year.

Forecasts for 2021

Forecasts for 2021
Source: Bloomberg, as at 29 May 2020.

What will happen now with the government bonds of countries that do not make any budgetary adjustments and whose debt ratios continue to climb? High debt levels alone do not automatically mean that a country will get into difficulties. This can be seen from the difference between Italy and Japan, both of which are highly indebted. Italy’s debt is expected to exceed 160 per cent of its GDP this year, while the figure for Japan is already over 260 per cent. Yet the two countries are viewed very differently in the capital markets. At the start of the coronavirus crisis in spring 2020, the yields on Italian government bonds shot up, but this was not the case for their Japanese counterparts. This is because it is not just the debt ratio but also the currency regime that determines whether government debt is sustainable. Unlike Italy, Japan has its own currency and its own central bank, and the BoJ is actually setting upper limits for market yields at present. This makes Japanese government bonds the safest investment in the national currency and they will remain so even if government debt rises.

When it joined the European Monetary Union, however, Italy ceded control over the currency in which its debt is denominated. Investors can switch to the bonds of other eurozone countries at any time, thereby triggering market turmoil.

Nevertheless, when a new eurozone crisis flared up in spring 2020, the heads of state and heads of government in the European Union made concerted efforts to contain it, establishing a European recovery fund in a resolution dated 21 June 2020. As a result, Italy and other member states that have been hit hard by the coronavirus crisis can fund part of their budget deficit with loans from the European Union; they will also receive direct grants. Tensions in the capital markets eased significantly as a result.

Yield premia on Italian government bonds decline sharply

Yield difference between ten-year German government bonds and ten-year Italian government bonds
Yield premia on Italian government bonds decline sharply
Source: Bloomberg, As of: 7. December 2020.

When it comes to assessing these debt problems, investors need to keep a clear head. Despite a sharp rise in debt ratios, eurozone countries can gain the trust of investors if, in the medium term, they manage to bring their debt level under control. This requires persistently low ECB base rates and political willingness to reduce budget deficits at member state level in the medium term. If both of these prerequisites are in place, bonds from eurozone periphery countries will become an attractive investment.

By contrast, when a country takes on debt in a currency that it controls through its own central bank, it should not be at risk of default even if its indebtedness continues to rise. This is the case for Australia, the United Kingdom and Canada. From an investor perspective, the biggest risks associated with government bonds from these countries are inflation and currency depreciation.

Background information: How is the sustainability of a government’s debt determined?

The primary balance is a crucial factor for debt levels. It consists of government revenue in the form of taxes and levies less primary expenditure in the form of staff costs, operating administrative expenses and transfer payments. Interest paid – the product of government debt (D) and the applicable interest rate (r) – is deducted from the primary balance (p). This gives the government budget balance.

If the primary balance is higher than the debt-stabilising primary balance (p*), government debt – as a percentage of GDP – goes down. If it is lower, debt will increase significantly. The debt-stabilising primary balance is the difference between the nominal interest rate of the government bonds (r) and the nominal trend growth rate of the country (g) multiplied by government debt (D). Expressed as a formula, this is: p* = (r-g) x D. The nominal trend growth rate consists of inflation and real growth.


As at 30 November 2020