Quick Thoughts: The Sovereign Debt Wave—an Existential Threat
The Sovereign Debt Wave is at a historic peak and appears set to continue growing. With higher inflation and reduced liquidity, some countries will be able to continue to issue debt easily, while some will not. Franklin Templeton Institute’s Stephen Dover and Kim Catechis discuss the different factors that will affect long-term investment returns for sovereign debt.
In our Deep Water Waves publication, we identified several powerful, connected and long-duration factors that will have a significant impact on investment returns over the next decades. One of these is the Debt Wave, driven primarily by a combination of economic, geopolitical and demographic pressures. We observe that the Sovereign Debt Wave is at a historic peak in terms of the US dollar value of the debt issued and appears set to continue growing. This was sustainable with low inflation and plentiful liquidity. These factors have both reversed, leading to a heightened urgency to raise capital. As a result, the traditional view on fiscal responsibility seems to have moved from the mainstream of political and economic policy debate to the fringes. Given several secular trends in place, this “wave” is apt to grow in depth and breadth. And that puts this debate at the center of policy decisions for a generation. This process drives an increasingly structural polarization between those countries that can easily continue to issue debt and refinance and those that cannot. Our paper on the subject can be accessed here.
- Even before COVID-19, the debt-to-gross-domestic-product (GDP) ratio was growing around the world.1 In the countries that powered global economic growth in the last generation (the United States, Europe and since 2009, China) debt is set to keep growing, as aging demographics raise the cost of pensions and health care, and working-age populations shrink. For lower-income economies with relatively fragile sovereign financials, continued access to affordable credit is an existential requirement.
- Many of the traditional mechanisms used to escape debt (economic growth through global trade) can no longer be taken for granted, due to the commingling of geopolitics and economics. In the long term, this is a challenge for China and the emerging markets. The policy of “friend-shoring” and the drive to diversify supply chains eliminates some of the most powerful catalysts helping these countries climb the knowledge ladder. This trajectory points to a widening polarization between developed countries and the rest.
- In these circumstances, developing economies are extremely exposed. The International Institute of Finance (IIF) calculates that the combined debt of the 30 large and developing countries has risen to US $98 trillion from US $75 trillion in 2019,2 pre-pandemic. Part of this surge is due to the collapse of their currencies against the US dollar, but the structural problem remains. Policy decisions made in the past have put them in financial quicksand, sinking deeper with every attempt to get out.