Global Sovereign Debt Trap

It is the central banks that are entrusted with the task of maintaining price stability in a nation. They did that with the classic tool of interest rates — raising them to curtail inflation when it was high, and cutting them when economic growth and inflation were low. But over years, central banks around the world over-stimulated prices and inflation by printing money and lowering interest rates.

After the 2008-09 Global Financial Crisis, bankers took on the responsibility of vanquishing all economic challenges. They battled economic stagnation by stimulating growth, fought unemployment by boosting industrial growth, subjugated economic slowdown by lowering interest rates, and promoted consumerism by printing more currency.

Now, retail inflation in the U.S. and Germany at 8.5% and 7.3%, respectively, is the highest since 1981. India is facing double-digit WPI inflation for the past year. But central bankers are missing in action. Lack of action against inflation from a community that never shied away from printing currency and heralding a negative interest rate regime is concerning.

Especially since the world is now in a debt trap. Any move to escape the debt trap quickly could sink the world into recession. Increasing interest rates is the only way to reduce debt proclivity. It means higher pay-out by indebted governments, corporates and households leading to lower disposable income, reducing demand, and in turn a slower economy.

Global Debt Trap

Today, the world is inundated with debt of nearly $300 trillion, according to the International Monetary Fund (IMF). A 1% interest rate hike will translate into $3 trillion in additional interest outgo, equivalent to India’s nominal GDP. Government debt on all reporting economies has risen from $54.3 trillion to $78.9 trillion between 2016 and June 2021, according to the Bureau of International Settlements. “We are caught in a debt trap and have been for decades. The current tightening cycle is taking hold at a time when the global economy is on a fragile footing and sensitive to slipping back into a downturn," says David Rosenberg, founder, Rosenberg Research and Associates.

Every nation loaded up debt while interest rates kept declining. In advanced economies, public debt rose from 70% of GDP in 2007, to 124% in 2020. According to the US treasury department data, current US government debt stands at $30.1 trillion and the 30-year mortgage rate is over 3%. Around $7 trillion was added between 2020 and 2021. Incidentally, it took 205 years — from 1776 to 1981 — for the U.S. to amass the first $1 trillion in debt. Around 96.7% of total U.S. government debt was accumulated in 40 years, from 1981.

India’s total general government debt (Centre plus states) to GDP ratio increased from 48.8% in the 1980s to 89.6% in FY21. Public debt (Central government liabilities) rose from ₹128 lakh crore in FY21 to a high of ₹135.87 lakh crore by March 2022.

“Debt is not an issue, per se, it is productivity that is important, which is often overlooked,” says Alfonso Peccatiello, editor of renowned newsletter, The Macro Compass, and a former fund manager. “Over the last 40 years we generated large amounts of unproductive debt that boosted asset prices rather than long-term structural growth.”

Until recently, interest rate cuts used to be the panacea for every economic crisis. The aging population of bigger economies — E.U., U.S., Japan — coupled with a pandemic-ensued economic slump, and the commodity-crisis induced by the Ukraine war, may bring a tectonic shift in the global financial model the world had been following for decades.

“The only way of dealing with this debt burden is through raising interest rates sharply and curtailing domestic demand,” says Ritesh Jain, a global macro investor based in Calgary, Canada.

The US Federal Reserve hiked rates by 25 basis points in mid-March and projected six more hikes this year. Many central banks plan to do the same, hinting at a shift from loose monetary policies to a higher interest rate regime. The world appears to be gearing up to tame inflation.

Aftermath of Low Interest Rate Policy

It all began in 1971, when the Bretton Woods Agreement was abrogated, de-anchoring sovereign currencies from gold. The de-anchoring ushered the world into an era of fiat currency whose worth depended on the perceived value of trust in the economy. The paradigm shifted when central banks started managing perception by creating illusory growth based on rising asset prices and booming capital markets.

Over the years, central banks focused on printing currency and lowering interest rates. The Fed's balance sheet expanded 5,462% to $8.9 trillion in April 2022 from just $160 billion in March 1981. Higher interest rate translates into higher risk. Hence interest rate serves as ‘investment hurdle’, ensuring productive utilisation of capital through debt instruments.

Between 1990 and 2021, global capital markets were pumped up with funds. In 2020, $11 trillion was pumped into capital markets through mergers and acquisitions (M&As), equity and bond issues against $700 billion in 1990.

The market capitalisation on the BSE grew from ₹90,836 crore in 1990-91 to ₹272 lakh crore as on April 13, 2022, a whopping 29,928% increase in 30 years. All major asset classes grew due to falling interest rates. Cheaper loans enabled welfare states to improve citizens' standard of living by providing food security, free education, medical insurance and development projects, which were funded easily by governments.

The Cost of Financial Abundance

The availability of cheap debt came with inflated asset prices, lax lending, defaults in repayment, unviable schemes promoted by governments to keep voters happy, unbridled consumerism, rising taxes, and blanket rise in inflation.

India’s 10 year G-sec yield that closed at 6.45% in December 2021 spiked by over 75 basis points to 7.21% on April 13. In the U.S., 10-year Treasury yields touched a three-year high of 2.71%, while average yield on Junk bond or high-yield bond in China rose to a multiyear high of 24.9%.

Till now growing debt was managed by using loose monetary policies of low interest rates and currency printing. But raging inflation in the developed world is making policymakers jittery. They have to choose between loose monetary policy that fuels inflation, or increase interest rates that may stimulate recession.

Impact on Indian Corporate and Consumers

Kenneth Andrade, founder and chief investment officer, Old Bridge Capital Management, says, “NSE 500 companies have clocked Ebitda margin of 17.3%, the highest in the past two decades. With rising margins, record profits and declining debt to equity ratio, Indian corporates are best suited to deal with rising interest rates.”

Reinforcing his faith in India Inc., Andrade says that in FY21, NSE 500 companies clocked a record ₹4.46 lakh crore of earnings while debt to equity has gone down to 0.7, a decade low, showing the strength of the balance sheet.

However, rising commodity cost and a pandemic-led demand drop has had a negative impact on consumer-oriented businesses. Anuj Poddar, executive director, Bajaj Electricals, says increasing WPI is a cause of concern for the economy. Like other electrical goods companies, Bajaj Electricals, too, hiked prices by 14-17% cumulatively in 2021. From April 2022, it hiked prices across product categories by 7%.

Dealing with High Interest Regime

While the end consumer could postpone purchases, investments will move towards the real economy. Andrade opines companies that deal with governments are going to stage a comeback on capital markets as the Centre is generating record revenue reflected in high Goods and Services Tax (GST) and fuel tax collection. The commodity crisis and high interest rates will force companies to innovate on supply chain and distribution models, financing, and products to retain demand in a tighter economic regime.

“Bajaj Electricals is value-engineering products for quality enhancement and stronger feature-led propositions. It also started hedging commodities such as aluminium, zinc and copper and is exploring strategic solutions against supply disruptions,” says Poddar.

Future Choices

One of the letters written by Thomas Jefferson, the third President of the U.S.A., reads: “I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared.” In the last 40 years, the U.S. has deviated from past ideologies. Today, it is facing the threat of de-dollarisation and high inflation.

High inflation is an aftermath of cheap debt. Although efforts to control inflation by raising interest rates would result in subsequent depression, the future will benefit from shifting focus towards productivity and prudent consumption. This may be the time to reflect upon what Benjamin Franklin said: “To preserve our independence, we must not let our rulers load us with perpetual debt. We must make our election between economy and liberty, or profusion and servitude.”