Debt damper

High US govt debt can increase risks

Irrespective of the outcome of the US presidential election in November, one issue poised to dominate policy discussions is the rapidly increasing US government debt stock. According to the US Treasury Department data, federal debt, which was at 123 per cent of gross domestic product (GDP) in 2023, has nearly doubled from the level of 63 per cent in 2007. Debt increased substantially following the financial crisis of 2008, and then further as a result of the pandemic. In absolute terms, government debt has crossed $33 trillion and the size of the US government bond market (or debt held by the public) recently crossed $27 trillion. While the US government bond market is considered to be the most liquid, which supports the dollar’s dominance as a reserve currency, the rapidly increasing size of the market is raising concern among some investors. Even a small dip in demand for US government paper can significantly increase interest rates.

According to the latest long-term projections of the Congressional Budget Office, released last week, the US government debt and deficit are expected to increase further in the coming decades. The average deficit over the next 30 years is expected to be 6.7 per cent of GDP, which would be 3 percentage points more than the past 50-year average. Debt held by the public is expected to increase to 166 per cent of GDP by 2054, which will substantially increase interest payments. The present level and the projected trajectory of US government debt can have a variety of implications for both the US economy and the rest of the world. A substantial increase in interest outgo would limit government expenditure in other areas, which can affect growth outcomes. Indeed, real potential GDP growth is expected to decline in the coming decades from an average of 2.4 per cent between 1994 and 2023. Relatively weak growth in the US will pull down global growth prospects. Given that another big driver of global growth, China, is also likely to slow, the global economy can be expected to remain relatively weak in the coming years.

Since the budget deficit in the US has moved up structurally, it will absorb more financial savings, and that can affect capital flows and make foreign-currency financing difficult for several developing countries. The financial markets are expecting the US Federal Reserve to start cutting interest rates later this year. The latest projections suggest that the Fed is on course to cut the policy rate by 75 basis points this year. While the expectation and actual rate cuts will ease global financial conditions in the coming quarters, the cost of money in the longer run in the US will be significantly swayed by the structural increase in deficit-financing needs. Since US government bonds are seen as risk-free and their yields determine asset prices in different segments, relatively high interest rates can induce significant volatility in financial markets. For a country like India, which depends on foreign savings to bridge its savings-investment gap, relatively high interest rates in the US and slower global growth could pose challenges. While global financial conditions are expected to ease in the near term, India should prepare to attract stable capital in the long run. In this context, boosting domestic savings will help reduce dependence on foreign capital.