The economic ripples of rising government debt

In recent years, governments worldwide witnessed a surge in debt levels. According to the Institute of International Finance, global debt reached a staggering USD 315 trillion in early 2024, with sizable increases in emerging market countries. This increase in borrowing, at least by governments, was partly driven by efforts to support economic recovery from the COVID-19 pandemic and increased the proportion of government budgets devoted to debt servicing. What happens when government debt climbs to such high levels?

Investors, concerned about an increased risk that sovereign bonds may default, often demand higher returns on new bonds, which translates into higher borrowing costs for governments. As government debt increases, the market adjusts by raising interest rates on new bonds, which increases the yield on new government bonds. While this means new investors see their returns increase, it also creates a burden on government finances. As yields rise, governments must spend more in interest to continue to borrow, which puts additional pressure on the budget. This can create a vicious cycle where high debt loads lead to even more debt and potentially foreshadow cuts to public services or efforts to increase taxes, which can reduce future economic growth. 

Decoding the risk premium

Our research, focusing on South Africa, examines how an expansion in government size—measured as government expenditure as a proportion of Gross Domestic Product (GDP)—triggers increases in the risk premium—measured as the yield or interest rate on sovereign bonds. We identify two key concepts: ‘government size shock’ and ‘spread shock’. A government size shock refers to a sudden increase in government spending relative to GDP. This increase makes investors wary of fiscal risks, leading them to demand higher returns on new long-term bonds, which raises yields. In this context, shock means an unexpected or sudden change, not a gradual increase. A spread shock refers to the widening gap between long-term and short-term yields on sovereign bonds. Spread shock is often due to elevated borrowing needs and heightened perceptions of long-term fiscal risk. While both shocks are influenced by increased borrowing, spread shock specifically highlights the changing relationship between long- and short-term yields, reflecting investors' expectations of future risks.We believe that understanding the relationship between government borrowing and risk premiums could help South African policymakers better navigate the economic landscape. By recognizing how sudden increases in government spending relative to GDP (government size shocks) and the widening gap between long-term and short-term yields (spread shocks) influence investor perceptions and borrowing costs, policymakers can make more informed decisions to mitigate fiscal risks and maintain economic stability.

Emerging market examples where such insights could have been beneficial include Mexico and Brazil. During the COVID-19 pandemic, Mexico experienced changes in its risk premium due to increased government borrowing, with government bonds seeing their risk premiums increase by more than one percentage point. This led to higher borrowing costs and underscored the need for careful fiscal management to maintain investor confidence. Similarly, in Brazil, rising debt levels led to increases in borrowing costs, reflecting greater perceived risk among investors. Despite already high public debt, Brazil's policy response to the pandemic included large-scale fiscal measures, such as a USD 30 billion fiscal boost to support vulnerable populations, maintaining employment, and bolstering healthcare systems. The measures helped stabilize the economy but also highlighted the importance of more sustainable debt levels to avoid long-term economic risks.

Why this matters

Our findings show that an increase in government size can exacerbate economic instability, particularly during downturns, especially when long-term yields on sovereign bonds rise in public debt markets. This rise in the risk premium has implications for monetary and fiscal policies. Central banks typically influence the economy by adjusting short-term interest rates, expecting these changes to affect key economic indicators. However, if public spending can influence investor perceptions and alter risk premiums, this can undermine the ability of monetary policy to achieve its goals.South Africa's experience over the past decade illustrates this dilemma, as efforts to lower short-term rates failed to stimulate long-term economic growth as anticipated.

A case in point is the 2015 drought, which had a considerable impact on South Africa's economy, leading to increased government spending on relief efforts. This additional spending, combined with an already strained budget, raised the sovereign risk premium, leading to higher borrowing costs and reduced liquidity, complicating monetary policy efforts to stimulate output. Similarly, during the COVID-19 pandemic, the South African government implemented large-scale fiscal measures to support vulnerable populations and stabilize the economy. However, these measures increased government debt levels, contributed to a rise in the risk premium, higher long-term yields, and ultimately limited the effectiveness of the South African Reserve Bank's efforts to support long-term economic recovery.

 A model for the future and implications for policymakers 

Our research documents how increases in government size, measured as government expenditure relative to GDP, significantly affect risk premiums, raising long-term yields. This effect is particularly pronounced during economic downturns, where heightened risk aversion already constrains credit liquidity and may reduce future economic growth.Using a New Keynesian model incorporating the term premium, we matched our empirical findings with model responses, confirming that rising risk premiums can obstruct the transmission of monetary policy. The model accurately replicates the empirical data, indicating that risk aversion during recessions is more than twice as high as during economic expansions. These insights show the delicate balance policymakers must strike in managing government debt and spending. For emerging economies like South Africa, understanding the interplay between government size, inflation, and economic growth is important. Our findings can inform strategies to stabilize the economy and foster sustainable growth, ensuring that fiscal policies do not inadvertently undermine monetary policy efforts.