In recent years, countries have notably shot up their debt using instruments such as rollover, but in their own way. Do you know what this tool is? Do you know how it works? Do you know why governments resort to it so much? Let’s see!
The monetary and fiscal expansion policies that are being carried out by different governments around the world are once again putting the focus of attention on a never-forgotten topic: public debt.
The reason is that, due to these policies, the indebtedness of many States has grown exponentially, which is forcing them to resort to rollover.
But what does this practice consist of? In this article we will explain and analyze it.
Different strategies, same goal
“Both are, in essence, budgetary stability strategies.”
In general terms, we can say that States tend to repay public debt in two ways.
The first, and most obvious, is to achieve a surplus in the public coffers, that is, a higher level of income than expenses. In this way, we can use that positive balance to pay back the borrowed capital when the debt reaches its maturity. It should be noted that this surplus can be achieved with ordinary income (taxes, fees, etc.) or extraordinary (such as the sale of state assets), or by cutting expenses in the budget, which we know as austerity policies.
This strategy, in reality, is nothing more than a debt reduction process. In other words, the solvency of the State is used to reduce the level of public debt. For many economists, it is one of the parts of the cyclical budget theory, which argues that states should borrow in times of crisis and get out of debt in boom years. In this way, the average level of public debt remains stable in the long term and only fluctuates according to economic cycles.
However, the great drawback of debt reduction is that it requires a prior surplus, something that many states are unable to achieve. Whether due to the structure of expenses and income, the inability of the authorities or even a lack of political will, there are countries in which the public deficit has become a chronic problem. What are these countries doing to pay their public debt?
The answer to this question is the second strategy that we mentioned to face the problem that concerns us here: rollover.
In reality, it is a resource as simple as issuing new debt to pay off the old one. In this way, states can meet their financial commitments without making budget adjustments or taking unpopular measures.
What is rollover?
«It is allowed to postpone the repayment of public debt without harming investors or compromising the credit quality of the country. »
Consider, for example, a country that has issued $ 1,000, 10-year bonds at 1% annual interest. Assuming they are bonds issued at par, the government will pay $ 10 per year for 10 years in interest, and after that time it would be enough to issue another $ 1,000 bond and use that money to return the initial capital. In this way, the net cash flow will be only $ 100 in 10 years, instead of the 1,100 that the State would have to pay if it decided to get out of debt.
The main advantage of rollover is precisely that it allows the State to maintain its solvency, even under adverse conditions. In addition, it gives governments a lot of flexibility, since it helps to postpone repayment of debt without harming investors or compromising the country’s credit quality.
Additionally, when interest rates fall, this strategy can even save financial costs. Returning to the previous example, if after the 10 years of maturity, interest rates have fallen and the Treasury can place its debt at 0.1% instead of the previous 1%, it can postpone the repayment of the debt another 10 years to change of only 1 dollar per year.
The situation in the world economy in the last 15 years, with two strong recessions and low interest rates, can help us understand why rollover has been the strategy chosen by most of the governments in the world. Quite simply, if states can delay the cancellation of their debts and also do it at minimal cost, politicians often have no incentive to make unpopular adjustments and pay off debt that can always be postponed.
«In the recessive period 2008-2014, Spanish debt grew at an annual average of 9.27% of GDP. However, during the subsequent expansionary cycle (2015-2019), this was only reduced to an annual average of 1.04% of GDP. “
Thus, if States can delay the cancellation of their debts, and also do it at minimal cost, what is the problem with this strategy then?
First, this policy completely breaks the long-term equilibrium that the cyclical budget pursues. Let us remember that the idea is that public deficits in years of crisis are offset by the surpluses that are registered when the economy grows. However, if governments do not take advantage of the growth years to get out of debt and instead increase spending even more, this mechanism cannot work.
Public debt in Spain, Italy, Ireland and the Netherlands expressed as a percentage of GDP during the period 2000-2020
Let’s look at a very recent example in the evolution of Spanish public debt. As we can see, in the recessive period 2008-2014 the debt grew at an annual average of 9.27% of GDP. However, during the subsequent expansionary cycle (2015-2019), this was only reduced to an annual average of 1.04% of GDP.
The reason is that as of 2014, and seeing the unpopularity of the fiscal austerity policies, the governments that have followed one another in Spain decided to take advantage of economic growth to increase public spending again. In doing so, they put debt reduction aside and instead continued to hope to maintain the debt rollover, encouraged by interest rates close to 0.
The graph shows us a similar evolution of debt in Italy, but opposite in Ireland and the Netherlands. In these cases, their governments did take advantage of the economic recovery to reduce their debt volume to more sustainable levels.
How could it be otherwise, the result is that now Italy and Spain are going through a new economic crisis with levels of public debt much higher than in 2008. This is one of the great dangers of rollover: it can be used occasionally in times of crisis, but if it is resorted to, also, when the situation is favorable, there is the possibility that the debt of the State will grow indefinitely. When this happens, we see that debt increases during recessions and remains stable in expansions, but never falls significantly.
Now, what is the problem if the debt continues to increase? If there is a possibility to do rollover indefinitely, why is it a problem that the level of public debt over GDP continues to grow?
When Public Debt Grows Too Much
«There is a danger that the solvency of the State does not depend on the discipline of its authorities but on exogenous factors such as interest rates. »
Let’s try to answer these questions by going back to the previous example.
Suppose that the country that issues bonds at 1% wants to roll over after 10 years, but finds that at that moment the conditions of the financial markets have changed, interest rates have risen and now it must place its debt at 5 %. If the public debt in that country represents 10% of GDP, the additional financial expenditure that the State must face would be barely 0.4% of GDP.
Suppose, instead, that the volume of public debt is not 10 but 100% of GDP, a fairly common figure today. In that case, the increase in interest rates would translate into an additional cost equivalent to 4% of GDP, which would be enough to throw any budget out of balance.
It is clear that in the first case, public finances can withstand an increase in interest rates without any problem. However, in the second, such a situation can trigger a sovereign debt crisis. In other words, when the level of debt over GDP is high, the State needs low interest rates, because only under these conditions is it capable of rollover and defaulting on its debt.
This leads to a dead end where governments have two options: try to get out of debt or, on the contrary, continue issuing new debt to pay off the old one.
The first alternative is usually very difficult when the total volume of debt is too high, because, perhaps, not even the State has enough assets to guarantee its repayment. The second may be more feasible in the short term, but it is also an added cost that is usually offset by unpopular measures, such as spending cuts or tax increases.
The danger consists, therefore, in letting the solvency of the State not depend on the fiscal discipline of its authorities, but on an exogenous factor such as interest rates in international financial markets. Factors that, in addition to changing, can sometimes also be unpredictable.
The Ant and the Grasshopper
“It is, in other words, the old story of the grasshopper and the ant brought into our global economy in the 21st century.”
The case of the United States that we observe in the graph below can help us understand this relationship between public policies and interest rates. Although we cannot speak of a perfect correlation between the two variables, it is evident that the period of greatest indebtedness of the federal government (2007-2012) also coincides with the greatest fall in the interest rates paid by the Treasury bonds at 10 years.
Evolution of public debt and interest rates in the United States in the period 2000-2020
NOTE: Public debt is expressed as a percentage of GDP (left axis), while for interest rates the average annual rate paid for 10-year Treasury bonds (right axis) has been taken as a reference. Sources: Macrotrends and Trading Economics.
We can therefore conclude that although this is not the only factor at play, low interest rates can encourage governments to run larger deficits and borrow more easily. The problem is that, as we have mentioned, indefinitely increasing the volume of debt may force a rollover on it in future environments, where interest rates are higher.
In this sense, it may be interesting to learn the lesson that Ireland and the Netherlands teach us.
In both cases, these are countries that have not renounced rollover to be able to get ahead in periods of crisis, but have reduced their debt again when they had the opportunity. Thanks to this, the Netherlands has been able to face the Covid-19 crisis with a ratio of public debt to GDP that is lower than in 2000.
In conclusion, we can say that rollover can be a very useful instrument if it is used together with debt reduction and both policies complement each other. However, if it is abused to indefinitely postpone the reduction of state liabilities, it runs the risk of entering a spiral of indebtedness from which it can be very difficult to get out.
We can find the key to this dilemma in the Dutch lesson, which teaches us the importance of deferring debts only in a crisis context, and repaying them as soon as the occasion allows it; even at the cost of great efforts. Very hard and even unpopular sacrifices, but thanks to which a country can face recessions without seeing its economy destabilized.
In other words, the old story of the grasshopper and the ant brought into our global economy in the 21st century.