Alfonso García Yubero: After the «war»



“First fight the war, then figure out how to pay for it,” said Carmen Reinhart, chief economist at the World Bank, last October. The unusual fiscal and monetary effort undertaken by most governments around the world has led to the level of public debt may close 2020 at levels only visited after the Second World War, exceeding on average levels of 120% of GDP in the case of developed economies. It has been a capital move to protect the economic capacity and survival of homes and businesses, but now that the light of the vaccines begins to reveal the rubble of a “war” that has not yet ended, one of the first concerns in the medium term concerns the issue of the debt itself: Is there a maximum limit?

Answering this question is complicated, perhaps even there is no answer. The consensus among economists is that As long as the economic growth of an advanced country is higher than the interest it pays on its debt, its additional debt margin will be comfortable. But the truth is that the credibility of the country plays a fundamental role: not only does it consist in being able to pay the interest, but also in showing that the current rulers and / or their successors will be able to repay the principal. Yes, this could be repaid by issuing new debt, but any investor will have to trust the country to acquire it and to comply with the minimum interest rate offered.

It is important to underline that we are talking about advanced economies, which can issue local currency debt on a large scale without having to face a crisis, known in the investment world as “hard currency” countries. They have stable governments and institutions and do not face the level of exchange rate vulnerability of some (many three decades ago) emerging countries. We know that its emission capacity is not infinite, but it cannot be calculated either: depends on the specific credit risk of each country, determined in real time by the market. It is not static, therefore, it fluctuates over time. In turn, credit risk, in general terms, depends on economic, financial, political and liquidity factors. Some of the metrics that we always keep in mind include ratios of public debt over GDP, fiscal deficit, interest rates, measures of political stability or imbalance in the current account balance. Together, these elements make up a country’s borrowing capacity. For example, why Japan – let me take an extreme case – can it issue massive amounts of debt in yen (its debt-to-GDP ratio was around 240% at the end of 2019)? To a great extent, due to the stability of its government, its institutional quality and respect for the rule of law.

During a crisis like the current one, any government must face the economic situation with a fiscal deficit today, and worry about reducing it tomorrow. As mentioned, although this leads to an increase in the cost of debt service, interest rates, historically low today, contain it. Now, and as has also been pointed out, it would be a mistake to think that the borrowing capacity is unlimited or to try to discern an exact frontier. We will only know that we have reached it when the cost of debt rises dramatically and the demand from foreign investors for paper in our local currency falls. And since no government wants to face such a scenario, the most convenient thing is to stay away from that hypothetical border, trying to reduce the level of accumulated debt, to promote higher future growth rates and thus mitigate risk.

To do this, governments will resort, and will continue to resort, to the historically most common tools: inflation and financial “repression.” The first decreases the real value of accumulated debt over time and the second keeps interest rates artificially low, acting as a kind of tax on savings. But the tool that can never be lacking in the debt reduction process is economic growth.. Let us trust that from the painful debris of the pandemic we can build solid productive infrastructures that will ensure a prosperous future for future generations.

Alfonso García Yubero is Director of Strategy Santander Private Banking

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