By now most are aware of the various metrics exposing the unsustainability of US debt (which at 103% of GDP, it is well above the Reinhart-Rogoff “viability” threshold of 80%; and where a return to just 5% in blended interest means total debt/GDP would double in under a decade all else equal simply thanks to the “magic” of compounding), although there is one that captures perhaps best of all the sad predicament the US self-funding state (where debt is used to fund nearly half of total US spending) finds itself in. It comes from Zhang Monan, researcher at the China Macroeconomic Research Platform: “The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP.“
This is a key statistic most forget when they discuss the stock and flow of US debt: because whereas the total US deficit, and thus net debt issuance, is about $1 trillion per year, one has to factor that there is between $3 and $4 trillion in maturities each year, which have to be offset by a matched amount of gross issuance just to keep the stock of debt flat (pre deficit funding). The assumption is that demand for this gross issuance will always exist as old maturities are rolled into new debt, however, this assumption is contingent on one very key variable: interest rates not rising.
It is the question of what happens to this ~$4 trillion in annual debt creation by the US, as well as other key ones, that Monan attempts to answer in the following paper on what happens to the world if and when the moment when rates truly start rising, instead of just undergo another theatrical 2-4 week push higher only to plunge over fears the Fed may soon pull the punchbowl.
By Zhang Monan, published first in Project Syndicate
The Real Interest-Rate Risk
Since 2007, the financial crisis has pushed the world into an era of low, if not near-zero, interest rates and quantitative easing, as most developed countries seek to reduce debt pressure and perpetuate fragile payment cycles. But, despite talk of easy money as the “new normal,” there is a strong risk that real (inflation-adjusted) interest rates will rise in the next decade.
Total capital assets of central banks worldwide amount to $18 trillion, or 19% of global GDP – twice the level of ten years ago. This gives them plenty of ammunition to guide market interest rates lower as they combat the weakest recovery since the Great Depression. In the United States, the Federal Reserve has lowered its benchmark interest rate ten times since August 2007, from 5.25% to a zone between zero and 0.25%, and has reduced the discount rate 12 times (by a total of 550 basis points since June 2006), to 0.75%. The European Central Bank has lowered its main refinancing rate eight times, by a total of 325 basis points, to 0.75%. The Bank of Japan has twice lowered its interest rate, which now stands at 0.1%. And the Bank of England has cut its benchmark rate nine times, by 525 points, to an all-time low of 0.5%.
But this vigorous attempt to reduce interest rates is distorting capital allocation. The US, with the world’s largest deficits and debt, is the biggest beneficiary of cheap financing. With the persistence of Europe’s sovereign-debt crisis, safe-haven effects have driven the yield of ten-year US Treasury bonds to their lowest level in 60 years, while the ten-year swap spread – the gap between a fixed-rate and a floating-rate payment stream – is negative, implying a real loss for investors.
The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP. As this figure continues to rise, investors will demand a higher risk premium, causing debt-service costs to rise. And, once the US economy shows signs of recovery and the Fed’s targets of 6.5% unemployment and 2.5% annual inflation are reached, the authorities will abandon quantitative easing and force real interest rates higher.
Japan, too, is now facing emerging interest-rate risks, as the proportion of public debt held by foreigners reaches a new high. While the yield on Japan’s ten-year bond has dropped to an all-time low in the last nine years, the biggest risk, as in the US, is a large increase in borrowing costs as investors demand higher risk premia.
Once Japan’s sovereign-debt market becomes unstable, refinancing difficulties will hit domestic financial institutions, which hold a massive volume of public debt on their balance sheets. The result will be chain reactions similar to those seen in Europe’s sovereign-debt crisis, with a vicious circle of sovereign and bank debt leading to credit-rating downgrades and a sharp increase in bond yields. Japan’s own debt crisis will then erupt with full force.
Viewed from creditors’ perspective, the age of cheap finance for the indebted countries is over. To some extent, the over-accumulation of US debt reflects the global perception of zero risk. As a result, the external-surplus countries (including China) essentially contribute to the suppression of long-term US interest rates, with the average US Treasury bond yield dropping 40% between 2000 and 2008. Thus, the more US debt that these countries buy, the more money they lose.
That is especially true of China, the world’s second-largest creditor country (and America’s largest creditor). But this arrangement is quickly becoming unsustainable. China’s far-reaching shift to a new growth model implies major structural and macroeconomic changes in the medium and long term. The renminbi’s unilateral revaluation will end, accompanied by the gradual easing of external liquidity pressure. With risk assets’ long-term valuation falling and pressure to prick price bubbles rising, China’s capital reserves will be insufficient to refinance the developed countries’ debts cheaply.
China is not alone. As a recent report by the international consultancy McKinsey & Company argues, the next decade will witness rising interest rates worldwide amid global economic rebalancing. For the time being, the developed economies remain weak, with central banks attempting to stimulate anemic demand. But the tendency in recent decades – and especially since 2007 – to suppress interest rates will be reversed within the next few years, owing mainly to rising investment from the developing countries.
Moreover, China’s aging population, and its strategy of boosting domestic consumption, will negatively affect global savings. The world may enter a new era in which investment demand exceeds desired savings – which means that real interest rates must rise.