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The "Swiss Re SONAR 2018: New emerging risk insights" report aims to get us talking about what tomorrow's risk landscape could look like.
Hamstrung?: The risks of heavy government debt
USD 174 trillion in mature markets and USD 63 trillion in emerging markets – 2017 continued to see the global debt stock rise to an all-time high of USD 237 trillion. This includes private and public debt. Ongoing low global rates have supported unprecedented levels of debt accumulation. Even though robust economic growth has pushed down debt-to-GDP ratios slightly, the high debt – especially government debt of USD 64 trillion – is too large to be ignored. This is because high debt puts a burden on the financial system and increases its fragility, limits growth potential and cuts the government’s flexibility to react to crises.
But how can the heavy debt burden be reduced? Historically, we have seen five different ways. A growing economy helps lower the debt-to-GDP ratio and lets people pay back their loans. Substantive fiscal adjustements are another way to cut at least the public debt. Explicit default, debt restructuring or a surprising uptick in inflation are less desirable or likely options. The fifth option is the steady dosage of financial repression with a steady dosage of inflation. As these debt-reduction channels are not mutally exclusive we have indeed seen a combination of these channels in the past.
The risk of corporate or even sovereign defaults may increase along with rising debt. While Japan’s 222% debt-to-GDP ratio still makes it one of the countries with the highest government debt burdens, the US continues to issue more debt from the current administration’s fiscal stimulus package. The government’s inability to tame its budget deficit could increase the – however remote – potential for a debt crisis. At some level, global investors may begin to be concerned about the US debt level. It may be that a possible debt crisis does not centre around a potential US default but more around how the government intends to manage the repayment of its debt and the impact this might have on the US economy. As US debt is mainly held abroad, what will happen if foreign creditors decide to use this situation to exert undue influence? US debt is therefore much more of a global issue than is the case in Japan where most of the debt is held domestically.
Given the high amount of debt, the economy and the financial markets are structurally more fragile than in the past. And we see very limited willingness by governments to address structural reforms. Therefore, financial markets could suffer from a domino-effect during the next severe downturn, with potentially higher government and corporate defaults than historically observed. Such default could wipe out lifelong savings of retail investors, potentially leading to strong political backlash.