Record Debt Issuance: A Looming Storm for Global Markets

The global financial landscape is on the brink of a seismic shift as governments of rich countries prepare to issue a record $17 trillion in bonds this year. This unprecedented surge in debt issuance, driven by the need to refinance existing debts at higher interest rates, is set to reshape global financial markets and investor confidence in profound ways.



The OECD's latest report paints a stark picture: inflation-adjusted interest rates are well above post-global financial crisis lows, while medium-term growth remains weak. This toxic combination raises the cost of servicing debt, adding to fiscal pressures and posing significant risks to financial stability. Governments are now faced with a daunting challenge: prioritize productive investments to ensure their borrowing supports long-term growth and productivity. Failure to do so could lead to a cascade of economic difficulties, as warned by Serdar Celik, OECD head of capital markets and financial institutions.

The short-term impact of this debt issuance is already being felt. Governments are grappling with higher interest bills, which are likely to continue rising as central banks withdraw from bond markets through quantitative tightening. This shift is forcing a growing share of bonds to be purchased by more price-sensitive investors, such as households and the non-bank financial sector. The dynamics of this new funding environment require close monitoring and a prudent policy approach to navigate the evolving risks.

Looking ahead, the long-term implications are even more concerning. The combination of higher costs and higher debt levels risks restricting the capacity for future borrowing at a time when investment needs are greater than ever. This is particularly alarming for emerging economies, where the amount of corporate bonds maturing in the next three years is significant, representing 51% (USD 4.4 trillion) of the total in 2023. The OECD warns that rising geopolitical tensions and trade uncertainties could lead to rapid changes in risk aversion, disrupting international portfolio flows and impacting investor confidence.

The OECD's report also highlights the potential economic and financial stability risks associated with increased debt levels. Around 40% of sovereign bonds and 37% of corporate bonds globally will mature by 2026, requiring further borrowing under higher interest rates. This will lead to growing financing pressures, particularly in emerging economies. Governments need to ensure their borrowing supports long-term growth and productivity. If not, we will see more difficult times.

Higher interest costs are another significant risk. Between 2021 and 2024, interest costs as a share of output rose from the lowest to the highest in the last 20 years. Even if inflation is brought down to central banks’ targets, yields will likely remain higher than when most of the debt was originally issued. Governments should focus on investment in areas that drive productivity increases and sustainable growth. This targeted spending can help offset the higher interest costs and ensure that the debt is used to enhance the economy's productive capacity.

The financial sector's health is also at risk. If improvements in governments’ primary balance cannot be achieved to offset higher real rates and lower potential growth, sovereign debt will continue to grow. This will test the financial sector’s health, potentially worsening the "bank-sovereign nexus" at high debt levels. Market supervisors should closely monitor the evolution of debt sustainability indicators in businesses and exposures in the financial sector. This monitoring can help identify and address potential risks early, ensuring the financial sector remains stable.

Geopolitical tensions and trade uncertainties add another layer of complexity. Rising geopolitical tensions and trade uncertainties could lead to rapid changes in risk aversion, disrupting international portfolio flows. This could exacerbate the challenges faced by countries with high debt levels. Policymakers need to be aware of these risks and develop strategies to mitigate them. This could include diversifying funding sources and strengthening domestic capital markets to reduce reliance on foreign investors.

The sustainable bond market, while growing rapidly, needs further improvements to enhance its efficiency and ensure that these bonds deliver the intended positive impacts for society and the environment. Adopting high-quality sustainable bond standards and requiring external reviews can help ensure that these bonds are used effectively to combat climate change and support sustainable development.

In conclusion, the record-high debt issuance by governments of rich countries poses significant economic and financial stability risks. However, these risks can be mitigated through targeted policy interventions, including ensuring that borrowing supports long-term growth, closely monitoring debt sustainability indicators, addressing geopolitical tensions, improving the sustainable bond market, and responsibly managing the federal debt limit. The path forward requires a delicate balance of fiscal prudence and strategic investment to navigate the stormy waters ahead.

Ask Aime: How can governments ensure their debt issuance supports long-term growth and productivity, while mitigating the risks posed to financial stability?