How risky is the high public debt in a context of low interest rates?

(article for the September Economic Review)

This article analyses the various challenges involved with public indebtedness in a context of low interest rates and estimates the sensitivity of interest charges on Belgium’s federal State debt to a fairly strong rise in interest rates in the future.

Government debt is high in Belgium, running at 102 % of GDP in 2018. This debt has risen sharply since the financial crisis, as it has also done in other euro area countries. Belgian general government debt reduction is still rather slow. According to the Bank’s latest macroeconomic projections, based on the assumption of unchanged policy, the debt ratio should remain above 100 % of GDP in the coming years.

Yet, interest charges paid for servicing the debt have been falling constantly over the last few years. This is the result of a marked fall in interest rates, which are now at their lowest level ever for most European countries. Belgian authorities also benefit from extremely favourable financing conditions. The cost of financing their national debt has never before been as low as it is today. 

Low interest rates have removed the risk of a snowball effect of interest charges on the public debt. However, the current situation of very low – even negative – interest rates cannot be considered as normal in the medium and long term and it would be reckless for fiscal policy and debt management to rely on the assumption that these favourable borrowing conditions will last.

Those in charge of managing the federal public debt have taken advantage of this low interest rate environment to extend the residual maturity of the debt from 6 years in 2010 to around 10 years in 2019. This is not something that is unique to Belgium, but it is more pronounced there than, on average, in the OECD and euro area countries. This strategy has reduced refinancing risks and definitely has its advantages if market interest rates were to go up in the coming years. But it also involves short-term costs. This article shows that it would only take a moderate, yet lasting, rise in interest rates for this strategy to seem more appropriate, in the long term, than keeping the residual maturity of the debt at its 2010 level.

Reducing the government debt must remain the key objective of fiscal policy in Belgium. This debt burden certainly makes Belgium vulnerable to a rate rise that may be expected at a later stage. Also, the financial markets seem to be paying more attention to the risks of a slippage in budget discipline or of unsustainable public finances than they did in the period preceding the financial crisis, which is reflected in interest rates. A steady decline in the debt ratio can help avert upward pressure on the spreads between Belgian and German government bonds and those of other euro area countries regarded as low-risk.

It is therefore advisable to use the budget margins resulting from low interest rates for supporting sound public finances and also to build up a sufficiently high primary balance in order to reduce the budget deficit and public debt.