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Kate Bettes
UNSW Business School

Among warnings of ‘perma-pandemics’ and digital threats, rising government debt is officially on the World Economic Forum’s watch list for 2023. 

The 2023 Global Risks report, which was published by the international lobbying group at the beginning of the year, said levels of debt held by countries were accruing and increasing the chance of default. 

The term ‘debt’ might make many of us think guiltily about credit cards or private mortgages. But when it comes to debt held by countries, the consequences of not paying national debt can have a massive impact – not just on the individual but on the population as a whole.  

Consider one country that defaulted on its debt semi-recently. Just last year, economic mismanagement and the COVID-19 crisis wiped out Sri Lanka’s tourism income. This resulted in a political crisis, which brewed from rising prices for basic goods, power blackouts and massive inflation. 

“Sri Lanka’s recent [economic] crisis provides a very real example of the spiralling risks to human security and health that can arise from economic distress,” commented the 2023 Global Risks report. 

Yet, Associate Professor Alexandre Jeanneret, School of Banking and Finance at UNSW Business School, says the report is being “a bit dramatic” when it comes to earmarking debt as a global and widespread risk. 

“The risk of widespread sovereign defaults isn’t that high, especially the risk of default contagion," he said, referring to possible spread of market disturbances across countries. 

So, what could happen as public debt rises? And how might it impact Australia and beyond? UNSW Business School academics explain. 

What is public debt default, and why is it a problem? 

Simply put, public debt default is when a nation state owes sums to a debt holder, and that nation breaches the agreement through late or non-payment.

It's a situation that is more common than you might think: Ghana, Sri Lanka and Russia all defaulted last year. 

Default contagion or ‘clustering’ is when economic disturbances spread – for example, when in 2001, Argentina underwent a financial crisis, it then impacted one of its main trading partners, Brazil. 

Gabriele Gratton, a Professor at the School of Economics, UNSW Business School, says there are clear political risks that come with high levels of public debt. 

“It may create tensions between sectors of the population who may have differential risks associated with the possibility of a default, or the consequences of austerity measures to avoid the default,” he says. 

Professor Gratton says such conflicts may lead to political instability with long term consequences.  

“In mild cases (as we’ve documented in our research paper 'From Weber to Kafka', American Economic Review) this may lead to the long-term deterioration of the quality of the bureaucracy, the legislation, and in general the functioning of the economy.  

“In more extreme cases, we may see the rise of illiberal regimes (see my recent work on “Liberty, Security, and Accountability”, forthcoming in Review of Economic Studies) or the rise of populist, majoritarian and illiberal demands that may even lead to the collapse of democratic institutions and the rise of autocracies.” 

"This can have knock-on effects as the perception of institutional, political, and economic instability may be contagious.” 

Why does the World Economic Forum think we are likely to see more sovereign debt defaults? 

There are lots of reasons countries might be more likely to default on their debt. A/Prof. Jeanneret says most countries have substantially increased their levels of debt. 

“One reason is that for the last decade interest rates were very low,” he explains. “When this happens, countries have an incentive to increase their indebtedness level because the cost of issuing additional debt drops substantially. The second is because of the pandemic crisis.” 

“Governments had to invest massive amounts of money to stimulate the economy with the aim of avoiding corporate bankruptcies and calming financial markets as well as giving monetary help for those who couldn't work.”   

(Australia was not immune to this. According to the 2021-22 Budget, the government’s gross debt will be around $963 billion as of 30 June 2022, and is predicted to rise.) 

The result is that lots of countries were left with a large debt level, says A/Prof.  Jeanneret, with a sharp contraction in economic activity, making for a high debt-to-GDP (gross domestic product) ratio.

To make matters worse for the countries in debt, interest rates have also taken an upturn, with central banks recently raising interest rates to fight inflationary pressure.  

And while the general layperson might only think of interest rate rises only in terms of personal debt, these rising interest rates affect countries with debt, too. A/Prof. Jeanneret – who recently conducted research into how shifting global macroeconomic conditions affect sovereign bond prices, which appeared in the Journal for Financial Economics – explains higher interest rates exposes countries to potential hazards.  

"All this creates refinancing risk,” he says. “When the debt is maturing, you need to replace it with new debt with a much higher interest rate, further increasing your debt burden. 

“It’s for this reason the World Economic Forum has warned of an increase in sovereign default risk.” 

Debt default unlikely to be contagious, says macroeconomist 

A/Prof. Jeanneret says one of the key reasons upcoming defaults are less likely to be contagious is that default is likely to occur in small countries in terms of economic importance, such as in Sri Lanka last year. 

“That is obviously very traumatic for people in Sri Lanka,” he points out.

“The sovereign default crisis raised unemployment and people had less income. Everything was more expensive because the local currency tends to depreciate. Because the country depends crucially on imports, such as energy, all prices were going up, while income was going down. 

“But for the world economy and the overall bond market, Sri Lanka is admittedly a tiny country. Also, most defaults in the near future will probably remain in small countries, so I don't think there will be the widespread sovereign default crisis that the report predicts.” 

The risk of contagion is limited when the country has less systemic importance: as in, how many trade links it has, or how important it is to other countries. For example, Argentina’s 2001 default put major pressure on its important trade partner, Brazil. 

"There can be a lot of isolated defaults with no crisis that leads to a default clustering, which is the main fear to bond investors,” A/Prof. Jeanneret explains. 

What countries might we see defaulting on their debt? 

When it comes to working out which country is vulnerable to defaulting, the macroeconomist says it is important to consider the economic environment. 

“Right now, we’re seeing a rise in interest rates, high inflation, low economic growth, and an increase in the value of the US dollar,” A/Prof. Jeanneret says. “Are these good or bad? Well, it depends on the country. Commodity exporters like Australia, Canada, or Chile might actually benefit from this state of affairs.” 

The economist also points out that while the rise in the value US dollar could be an issue when a country holds their debt in US dollars, and has to pay more down the track, it can actually be a benefit for others who are net exporters. 

“But those countries that do not export or produce commodity goods, such as Sri Lanka, are the ones that will suffer the most from rising inflation.” 

All of this can have significant political impact. Eight years before the Sri Lankan president had to flee the country, the Arab Spring uprising was partly caused by an increase in the price of imported wheat to unaffordable levels, which the North African countries heavily relied on. 

But while A/Prof. Jeanneret says the report is along the right lines in identifying that there are markets at risk of default – such as Argentina, Egypt, Ghana, Kenya, Tunisia, Pakistan and Türkiye – there is most likely a limit to how much damage that can occur. 

See also: Tens of thousands have been laid off in tech: what will happen next?