Fixed Income Special Debt sustainability on the radar

Fixed Income Special Debt sustainability on the radar

Ninon Bachet Key points  Debt remains sustainable across the countries analysed, but vulnerabilities are greatest Mathias Kpade in the US and Italy, while Germany retains the strongest buffer.  Long debt maturities delay the pass-through of higher yields, although the US is more exposed due to its shorter maturity profile and heavier reliance on bills.

 The withdrawal of central banks has increased sovereigns’ reliance on more price- sensitive and leveraged investors, raising the risk of volatile flows and refinancing pressures, particularly in France and Italy.

 High-debt countries are particularly vulnerable to growth shocks, while for the others risks to growth and fiscal slippage are more symmetric.

Recommendation This document is an aggregation of analysis published gradually in FI Weeklies since early May.

Back to basics As yields reach new highs across jurisdictions, questions over the debt sustainability are emerging.

What does sustainability mean? A country’s public debt is considered sustainable if the government is able to meet all current and future payment obligations without exceptional financial assistance or going into default (IMF). The long-term trajectory of debt depends on fiscal policy (primary balance, pb), interest rates (r) and nominal economic growth (g). Intuitively, for a given primary balance, the larger the interest rate-growth differential (r–g), the more the debt ratio will increase, while when r < g, the debt ratio tends to decline. Two rates thresholds, to be compared with the actual cost of borrowing, are particularly relevant:

▪ The stabilisation rate: the average interest rate at which a government can stabilise its debt-to-GDP ratio, given nominal growth, the primary balance and the debt stock inherited from the previous year. 𝑝𝑏𝑡 (1 + 𝑔𝑡 ) 𝑟𝑡∗ ≈ 𝑔𝑡 + 𝑑𝑡−1

▪ The stress threshold: the average interest rate at which debt servicing reaches levels considered difficult to sustain, either because it absorbs a large share of public revenues or exceeds the government’s capacity to generate primary surpluses. Interest payments equivalent to 5% of GDP are commonly viewed as a critical threshold. We take this conservative level as our central hypothesis. 5% r𝑡∗∗ = 𝑑𝑡−1

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We can then calculate two metrics: 1/ the stabilisation buffer i.e. the difference between the average interest rate and the stabilisation rate and 2/ the sustainability buffer i.e. the difference between the average interest rate and the stress threshold.

Key levels to keep in mind Computing these metrics for the four largest EA countries, the UK, the US and Japan (Table 1, Graphs 1-6) yields logical conclusions:

- In France, Germany, the US and the UK, average interest rates are above the stabilisation rate, implying a mechanical increase in debt-to-GDP (and a negative stabilisation buffer). This largely reflects primary deficits compressing the stabilisation rate. The opposite holds for Spain, Italy and Japan.

- Borrowing costs remain below the stress threshold in all countries (positive sustainability buffer):

• The gap is the widest in Germany, indicating a substantial buffer before debt sustainability becomes a concern, even in the context of current and expected fiscal stimulus.

• The margin is relatively large in France, Spain, the UK and Japan. However, in France, the stress threshold is declining while the average interest rate is rising, narrowing sustainability buffer. In Spain, the stress threshold is increasing (less visible in the chart due to scaling), supporting a rebuilding of the sustainability buffer. In the UK and Japan, the sustainability buffer is lower but relatively stable.

• The buffer is the smallest in Italy, leaving it closest to potential sustainability concerns. While the stress threshold is broadly stable, the key issue for Italy remains the elevated debt stock, which keeps servicing costs high. The buffer is also narrowest in the US reflecting a large primary deficit alongside rising interest costs. However, the dollar's…