Deep waves: The sovereign debt wave—an existential threat

Foreword

In our Deep Water Waves publication, we identified several powerful, connected, and long-duration factors that will have a significant impact on investment returns over the next decades. One of these is the Debt Wave, driven primarily by a combination of economic, geopolitical, and demographic pressures. We observe that the Debt Wave is at a historic peak in terms of the US dollar value of the debt in issue and appears set to continue growing. This was sustainable with low inflation and plentiful liquidity. These factors have both reversed, leading to a heightened urgency to raise capital. As a result, the traditional view on fiscal responsibility seems to have moved from the mainstream of political and economic policy debate to the fringes. Given several secular trends in place, this “wave” is apt to grow in depth and breadth. This process drives an increasingly structural polarization between those countries that can easily continue to issue debt and refinance, and those that cannot.

This paper focuses on sovereign debt, examines the drivers of these changes, and offers conclusions on their investment implications.

Executive summary

We believe we need a massive reallocation of resources, which implies a need for positive real interest rates because there will be so much issuance from both governments and the private sector that there will be competition for investors’ cash. There is an opportunity for private debt to arbitrage, but default risk is probably higher overall. The traditional sources of long-term savings might be squeezed or even reduced over time, as the working populations in mostly high-income countries shrink and their costs increase. There will be increasing government intervention in most countries—not always efficiently or even usefully. In our opinion, this scenario makes every investment decision loaded with implicit factor weights that are not currently mainstream.

• Even before COVID-19, the debt-to- gross-domestic- product (GDP) ratio was growing around the world.¹ In the countries that powered global economic growth in the last generation (the United States, Europe and since 2009, China) debt is set to keep growing, as aging demographics raise the cost of pensions and healthcare and working-age populations shrink. For lower-income economies with relatively fragile sovereign financials, continued access to affordable credit is an existential requirement.
• The traditional view on “fiscal responsibility” seems to have moved from the mainstream of political and economic policy debate to the fringes. Given several secular trends in place, the importance of this issue is set to grow in depth and breadth. This process drives an increasingly structural polarization between those countries that can easily continue to issue debt and refinance, and those that cannot. And that puts this debate at the center of policy decisions for a generation.
• Many of the traditional mechanisms used to escape debt (economic growth via global trade) can no longer be taken for granted, due to the commingling of geopolitics and economics. In the long term, this is a challenge for China and the emerging markets. The policy of “friend shoring” and the drive to diversify supply chains eliminates some of the most powerful catalysts helping these countries climb the knowledge ladder. This trajectory points to a widening polarization between developed countries and the rest.
• In fact, the chances of inserting a particular country into the crucial international supply chains are greatly improved if it can play the geoeconomic Great Game.² A country needs a sizeable population to attract foreign direct investments (FDI), a commercial and industrial ecosystem that is used to operating in international markets, as well as unexploited mineral wealth—especially if those minerals are relevant for the green transition or for electric vehicles (EVs) or defense. Mexico and Indonesia clearly have a window of opportunity, which implies they could take advantage of the current geopolitical climate to leverage financing and/or favorable market access.
• In these circumstances, developing economies are extremely exposed. The International Institute of Finance (IIF) calculates that the combined debt of the 30 large and developing countries has risen to US$98 trillion from US$75 trillion in 2019,³ pre-pandemic. Part of this surge is due to the collapse of their currencies against the US dollar, but the structural problem remains. Policy decisions made in the past have put them in financial quicksand, sinking deeper with every attempt to get out.
• We examine the widely held theory of China’s predatory lending and provide two country case studies. The conclusion is that there is no evidence of a master plan using sovereign debt. History suggests that many borrowing governments have consciously chosen less-economically sensible credit to avoid scrutiny and conditionality. Observers find grounds for discomfort, but not for panic.