The implications of excessive government debt

By Gary Anders

As the pandemic swept across the planet in 2020, at its heels was a tidal wave of public sector spending.

In many respects, the accumulation of a colossal global debt was inevitable. To combat the pandemic on a health response level and simultaneously fund financial relief packages required to support affected businesses and households, governments around the world needed to borrow money on a massive scale.

Sources of financing

Governments often go to the global bond market to borrow funds. Most governments issue fixed income debt securities via the bond market on an ongoing basis.

During the pandemic, however, governments needed to borrow on a scale most countries have never seen. They have largely done this by issuing tens of trillions of dollars of bonds in multiple tranches, which have been snapped up by eager bond investors worldwide.

Funding the pandemic crisis responses involved a monumental transfer of investment capital to governments. The capital raised by governments was then used for economic stimulus packages.

Over a two-year period starting in March 2020, the Australian Government progressively issued more than A$350 billion of bond securities via the Australian Office of Financial Management (AOFM) to finance pandemic measures, including the A$90 billion JobKeeper Payment program.

Increased borrowing

While the COVID crisis has largely abated, the need for governments to borrow money has been increasing over time and does not appear to be subsiding.

This is apparent from the record number of government bond issues in 2023, met by a seemingly insatiable demand from professional investment managers around the world. Driving the demand are investors seeking higher interest rate returns.

In a 2023 report titled A World of Debt, the United Nations Conference on Trade and Development (UNCTAD) notes that global government debt has been rising sharply over recent decades, from US$22 trillion (A$33.2 trillion) in 2000 to a record US$92 trillion (A$138.8 trillion) at the end of 2022.

According to UNCTAD, at the end of 2022, around 70 per cent of total government debt was owed by developed countries. Yet government debt has increased at a faster rate in developing countries due to growing development financing needs and, exacerbated by COVID, the cost-of-living crisis, climate change and limited alternative sources of financing.

“Consequently, the number of countries facing high levels of debt has increased sharply from only 22 countries in 2011 to 59 countries in 2022,” UNCTAD says.

“Developing countries face additional major challenges due to high levels of external public debt, which makes them more vulnerable to external shocks.”

UNCTAD defines high levels of debt using “a representative threshold of a public debt to GDP ratio of 60 per cent”. The burden posed by that debt differs across countries.

Credit quality – the ability of governments to meet their debt repayment obligations – is a growing concern. More than a dozen countries have defaulted on their debt repayments to bondholders since 2020, and credit ratings agencies have a list of others on the verge of defaulting.

The US is at the top of the global pile ending 2023 with almost US$34 trillion (A$51.3 trillion) of debt. After raising the debt ceiling to US$31.4 trillion (A$47 trillion) in January 2023, in June 2023 the debt ceiling was suspended until 2025, when US President Joe Biden signed the Fiscal Responsibility Act of 2023 into law.

While an unprecedented default on the US Government’s debt was averted, it was not enough to avoid ratings agency Fitch downgrading the country’s long-term AAA credit rating to AA+.

Growing competition for government debt

Interest rates were at record lows in early 2022. They have soared since then as central banks have aggressively lifted their official rates to dampen surging inflation levels.

The higher fixed interest rates payable on new bond issues have become increasingly attractive for many investors, leading to record inflows into bond market securities in 2023.

Warren Hogan, managing director and founder of EQ Economics, says the growing competition for investment capital means governments will have less flexibility in the future to raise debt to fund public services and infrastructure.

“At the moment, the capacity to finance government deficits has been quite straightforward and hasn’t put a lot of upward pressure on interest rates,” he says. “It’s the future that we worry about. Can governments respond to the next crisis? Can they keep record borrowings? Do they need to try and run less deficits?”

Australia currently has almost A$900 billion of outstanding government securities on issue.

The 2023–24 Federal Budget forecasts further increases in Australia’s gross debt to A$1.067 trillion (36.5 per cent of GDP) by the end of the 2026–27 financial year.

As part of this, the AOFM is planning to issue A$75 billion in new Treasury bonds for the financial year ending 30 June 2024, with the money raised likely to be used to continue funding government infrastructure as well as incentives for households.

The Australian Government has also committed to introducing a “green bond” program to enable investors to back public projects that will drive Australia’s net zero transformation and support environmental objectives.

The first issue of green bonds is scheduled for mid-2024, following the release of a green bond framework being developed by the Treasury and the AOFM in consultation with investors.

“We’ve seen a whole lot of issuances globally by major sovereigns and indeed by Australian states,” says Simon O’Connor, chief executive officer of the Responsible Investment Association Australasia.

“Australia has been quite slow at a federal or sovereign level to start a program of issuances.

“We’re certainly pleased to see this moving forward, because we see it as a really effective means of raising additional capital to accelerate investments in the low carbon transition. I think also we see that from an investor side, where we sit with our membership, there’s a huge appetite to find issuances or securities to invest in that are directly targeting low carbon assets.”

O’Connor says the high investment attraction for government-backed green bond programs compares with the lower demand, at this stage, for so-called impact investments, such as government-backed affordable housing projects.

“When we talk specifically in the Australian context, they are relatively small amounts of capital that are flowing to impact investments.

It is something in the order of A$30 billion in the last year of assets under management compared to a responsible investment market of A$1.4 trillion.”

How much government debt is too much?

How much governments borrow comes down to individual fiscal policies, which generally determine the proportion of recurrent spending that should be funded by borrowings, complemented by other major sources of government cash flow, such as from tax receipts.

Economist Saul Eslake says that Australia’s current government debt, as a percentage of GDP at above 30 per cent, could be considered high. However, he points out that government debt in the UK and the US is over 100 per cent of GDP, and in Japan, it is over 200 per cent.

“So, yes, we have a problem, and interest on public debt – along with spending on health and aged care, defence, and the NDIS – is one of the fastest growing areas of government spending,” Eslake says. “However, it is a more manageable problem than the one that is confronting most of the countries we compare ourselves with. 

“There is no rule of economics or public finance that says the optimal level of debt for a government is zero.”

Eslake says it is entirely rational and appropriate for governments to fund at least some of their infrastructure spending by borrowing, because the infrastructure will presumably benefit future generations of taxpayers.

“Requiring those future generations to service debt that has been used to fund some of that infrastructure is a way of making them pay for it, rather than if governments always ran budget surpluses and didn’t have any debt,” he says.

“So, there’s no requirement that all the debt be paid off. How much debt should be paid off really depends on what you think is an acceptable proportion of revenue to devote to interest. Some governments use rules of thumb like between 4 per cent and 6 per cent or so of revenue.”

A matter of interest

High debt levels translate into high interest payments. In the lead-up to the 2023–24 Federal Budget, Treasurer Jim Chalmers revealed that interest payments on Australian government debt will cost taxpayers A$112 billion over five years.

That equates to more than A$61 million per day – even with the significant financial benefit flowing from Australia’s strong AAA credit rating assigned by global agencies Standard & Poor’s (S&P), Moody’s and Fitch.

In assessing the ability of governments to service and repay their debts, credit rating agencies examine both the total level of outstanding debt as well as the interest rates being paid on that debt. Most governments value their outstanding debt based on prevailing bond market prices.

S&P analyst Anthony Walker says the economic outlook for Australia is sound, although real GDP growth will slow in response to the Reserve Bank’s interest rate actions.

“Australia’s economy will likely avoid recession and expand over the next three years. This reflects low unemployment and high commodity prices. Australia benefits from being a net energy exporter.”

Walker says the budget deficit and total government debt are on track to improve over the coming years.

“Reinforcing our assessment of Australia’s fiscal position is our view that it has displayed more willingness than its peers to raise revenues and contain expenditures.”

Paying it back

When bonds are issued by governments and corporates, the investors buying them effectively lend their money in return for set regular fixed interest payments and the full repayment of their capital if they hold their bonds until the issue’s maturity date.

A burning question may be, how long do governments have to repay their debt?

In Australia’s case, the bulk of bond issues by AOFM are in the 10-year maturity range, although the issuer now also has a 30-year bond program in place with a June 2051 maturity date.

That is a long investment duration – and a long government repayment plan – but it is nowhere near as long as some other government bond issues launched during the pandemic.

Indonesia, for example, went to the bond market in 2020 with a 50-year bond issue to raise US$1 billion (A$1.51 billion), the first of that duration in Asia. Israel topped that by issuing its first 100-year bond, also to raise US$1 billion (A$1.51 billion), followed by a 40-year issue to raise a further US$5 billion (A$7.55 billion).

The bottom line is that governments issuing debt securities have total control over their own repayment terms.

Consider that the UK has only recently started paying off a consolidated loan as part of a redemption of multiple bond programs spanning back 300 years. They include bonds issued during the 1720 South Sea Bubble financial crisis, the 1815 Battle of Waterloo, the Crimean War against Russia in the mid-1850s and bonds issued during the First World War.

It is a salutary lesson. While COVID may be forgotten decades from now, the pandemic will likely live on for future generations of taxpayers as governments slowly pay off their accrued liabilities.