Reducing Debt: Extent, Restrictions, and Consequences

Politiques publiques | Les pays

Wassim MANSSOURI - 24/06/2024

Reducing Debt, Whatever It Takes?

In modern economies, government debt has become a major problem with many nations struggling to balance their debt levels and budgetary balances. Achieving fiscal sustainability demands reducing government debt, but doing so is a complex and diverse subject that calls for carefully weighing the advantages and disadvantages. On one hand, reducing government debt can result in a stronger fiscal position, lower borrowing costs, and increased economic stability. However, it can also have the opposite effect, leading to reduced government spending, higher unemployment, and a potential slowdown in economic growth.

This paper aims to engage in the ongoing discussion about the optimal level of public debt and the best strategies for achieving fiscal sustainability by examining the relevant theoretical and empirical evidence, highlighting the sovereign debt profile of the Arab region and the Lebanese experience facing an extensive government debt. This is sought through providing an overview of the current state of government debt and its implications for economic stability. Secondly, this study presents a comprehensive analysis of the benefits and drawbacks of reducing government debt. Thirdly, it examines the required budgetary restrictions and the consequences that may result from this course of action. Finally, the main findings are summarized and recommendations are provided for policymakers seeking to achieve fiscal sustainability.

1 – Overview of the Current State of Government Debt: the Global, Regional, and Lebanese Perspectives

According to the United Nations, global debt, comprising both domestic and external general government borrowing, recorded an unprecedented rise. It reached a historic peak of $97 trillion in 2023, up by $5.6 trillion from the previous year, and recording a 40% increase since 2019[i].

Figure 1: Public Debt Levels in 2023

Particularly in Africa, economies have witnessed a heavier debt burden. The number of African countries with debt-to-GDP ratios above 60% has increased from 6 to 27 between 2013 and 2023. As repaying debt has become more costly, this is hitting developing countries disproportionately. Developing countries paid $847 billion (a 26% increase from 2021) in net interest in 2023. Their foreign borrowing rates were two to four times higher than those of the United States and six to twelve times higher than those of Germany. Budgets in developing nations are being strained by the quick increase in interest rates. Currently, half of them designate at least 8% of government revenue for debt service, a figure that has doubled over the last ten years. This indebtedness is limiting the developing countries’ capacity to tackle major sustainability challenges. For example, governments of developing countries are currently allocating a larger proportion of their GDP to interest payments (2.4%), than to climate initiatives (2.1%). Moreover, 3.3 billion individuals reside in nations where interest payments exceed spending on either education or health[ii].

Figure 2: Comparative Borrowing Costs

On the regional level, after reaching a historical peak of 80.1% in 2020, the average government debt-to-GDP ratio in the Arab region fell to 58.8% in 2022 and 68.1% in 2021. This reduction was brought about by a decrease in public debt in addition to improved economic growth in most Arab countries[iii].

Figure 3: The Average Government Debt-to-GDP Ratio and the Change in Ratio in the Arab Countries (%)

However, banks dominate the Arab government debt markets although the investor base of treasury securities varies widely across Arab countries. In 2022, approximately 10% of the consolidated assets of the Arab banking sector were invested in central government debt (excluding other public sector entities). This percentage rises to an average of 18% for middle-income Arab countries. This interconnectedness between fiscal position and bank lending to the government results in a sovereign-bank nexus phenomenon in the Arab region, which poses risks to fiscal sustainability and financial stability[iv]. Banks’ extensive holdings of government debt mean that any fiscal instability directly impacts the financial sector. This nexus also creates a feedback loop where fiscal issues exacerbate financial sector vulnerabilities, and vice versa[v]. Hence, the high levels of bank holdings of government debt in several Arab countries may result in two repercussions: firstly, high exposure of banks to sovereign risk and ratings downgrade following sovereign downgrade; and secondly, crowding out effects for the private sector and depriving businesses from the needed funding[vi].

Figure 4: Government Debt Held by Banks as Percent of the Consolidated Assets of the Arab Banking Sector (%)

The current state of government debt in the MENA region is characterized by the following:

High debt levels: Many MENA countries have high debt levels, with some countries’ debt-to-GDP ratios exceeding 90%, which increases the risk of debt crises[vii].
High cost: The cost of excessive sovereign debt accumulation comprises the following: the debt service cost; the possibility of debt distress and increased vulnerability to financial crises; constraints on fiscal policy space and effectiveness especially during economic downturns; and the possible crowding out of productivity-enhancing private sector investment.
Debt composition: The debt composition in MENA countries is a mix of domestic and external debt. Domestic debt is often held by local banks and pensions, making it difficult to restructure[viii].
Fiscal challenges: MENA countries face significant fiscal challenges, including declining fiscal revenues, deteriorating public finances, and a lack of fiscal space, in addition to sociopolitical pressures, making it challenging for governments to implement necessary reforms[ix]^, [x].
Economic growth: The region’s economic growth prospects are weak, with high inflation and persistent economic contraction in some countries[xi].
Regional differences: MENA countries have different debt profiles and require distinct and tailored approaches to addressing their debt issues[xii].

On the Lebanese level, the country has been facing stressful conditions for the fifth consecutive year following the protests of October 17, 2019, and the subsequent extraordinary economic and financial breakdown. This has led to a multi-dimensional crisis, aggravated by global and regional economic turbulences. Lebanon’s crisis emerged after a decade of regional turmoil, particularly regarding the repercussions and risks of the Syrian war, on the one hand, and the difficulties in public finances in terms of the budget deficit and the exacerbation of public debt and its service on the other hand. This crisis was exacerbated due to several factors: the inflationary monetary-financial factor that is embodied by foreign-currency liquidity shortage, exchange rate devaluation, and imbalance in the balance of payments, as well as the government’s decision to discontinue payments on all its outstanding US dollar-denominated Eurobonds in March 2020; the COVID-19 pandemic consequences and Beirut Port explosion factor; and the prolonged political paralysis leaving the country with presidential and executive vacuum. Accordingly, standards of living in Lebanon have been worsening dramatically with all sectors being affected: the health system, the power and electricity with the shortage in fuel and spike in energy prices, the education system, and the banking and financial sectors.

Lebanon hosts the highest per capita concentration of refugees/displaced people in the world. According to UNHCR, Lebanon hosts around 1.5 million displaced Syrians, many of whom are not registered, amounting to 27% of the total population in Lebanon[xiii]. The Syrian displacement crisis that started in 2011 has had a considerable impact on the Lebanese economy. The unexpectedly large flow of displaced Syrians has strained the already unbalanced public finances, unstable public service delivery, infrastructure, labor market, and the environment. Public services are particularly burdened to meet the amplified demand, with health, education, electricity, communication, water, and sanitation requirements. The latest World Bank report estimated Lebanon’s economic losses caused by the Syrian conflict, in terms of lower real GDP, at 2-3 percentage points annually until 2017, equivalent to around $31 billion. Total investment declined by around 20% while imports and exports decreased by around 35% and 45% respectively due to the conflict. Moreover, recurring annual gross costs[1] of hosting Syrian refugees in Lebanon are estimated at $1.55 billion[xiv]. As for foreign direct investment, its average net inflows to GDP declined from 12.6% between 2003 and 2010 to 5.2% of GDP between 2011 and 2021[xv].

Figure 5: A Comparative Distribution of Syrian Displaced Populations in 2023

Source: UNHCR data (except for Lebanon, where the source used is the Lebanese General Security and the Directorate General of Personal Status)[xvi]

One of the major outcomes of Lebanon’s strenuous socioeconomic reality was the surge in its public debt with its debt service burden inflicted on the Lebanese fiscal space. Lebanon’s sovereign debt profile can be formulated by tracing Lebanon’s public debt levels, debt composition, and the incurred costs of debt.

Global World Bank estimations establish a debt-to-GDP ratio threshold of 64% for emerging markets. In these countries, each additional percentage point in public debt causes a loss of 0.02 percentage points in annual real growth[xvii]. Lebanese public debt surpassed this threshold early in 1993. It continued escalating reaching a peak of 183% in 2006, with a budget deficit of -38.4%, before decreasing gradually to 131% in 2012, with a budget deficit of -20.1% in 2011 and an annual average growth rate of 9% between 2007 and 2010. However, this momentum was unfortunately not sustainable and did not last long due to political instability, macro-financial mismanagement, the repercussions of the Syrian war, and the COVID-19 pandemic. Hence, the public debt-to-GDP ratio resumed its erosion to pre-Syrian crisis levels reaching 179% in 2022, which is among the highest in the world and the Arab region. This was driven by a sharp contraction of the real GDP by 56% in 2020 and 2021 despite a budget surplus recording 12.1% in 2021 due to eliminating a large part of the debt service after defaulting on Eurobonds in 2020[xviii]. GDP per capita also dropped by 36.5% between 2019 and 2021, and Lebanon was reclassified by the World Bank as a lower-middle-income country, down from upper-middle-income status in July 2022[xix].

Figure 6: GDP Growth, Debt to GDP, and Budget Deficit/Surplus (1993 – 2022)

Source: World Bank and Lebanese Ministry of Finance

As for debt composition, domestic public debt constituted the main part of the Lebanese public debt in most of the years where the Lebanese government relied on domestic market borrowing until 2019 when it peaked at $91.6 billion. During that period, external public debt comprised 39.4% of the overall public debt before its share increased substantially with the outburst of the financial crisis. It now forms the bulk of the public debt after the sharp decrease in the Lebanese Pound exchange rate which lost more than 98% of its pre-crisis value[xx].

Figure 7: Lebanese Public Debt Level and Composition

The cost of public debt service followed an escalating trend between the years 2002 and 2018, increasing from $3.1 billion in 2002 to $5.3 billion in 2018. Even though the ratio of this cost to total revenues decreased from 80.6% (16.6% of GDP) in 2002 to 39.4% (9% of GDP) in 2018, the continuous accumulation of debt service amid an environment of subdued growth undermined sovereign debt sustainability and exhausted fiscal space, leading to the outburst of the financial crisis in 2019[xxi].

Figure 8: Cost of Debt Service (2002 – 2018)

Consequently, the public debt burden in Lebanon has a dual impact[xxii]:

On the fiscal space level: Managing the high levels of the debt service burden requires prudent macroeconomic performance. Lebanon faces significant challenges in this matter, thus constraining its fiscal space and limiting the government’s ability to invest in essential public services and infrastructure. This situation has led to increased borrowing and higher taxes, further straining the economy.
On the sovereign risk and financial stability levels: As part of the Arab sovereign-bank nexus syndrome, Lebanon’s banking sector holds a substantial portion of government debt, which makes it heavily intertwined with the government’s debt situation and exposes it to significant sovereign risk and fiscal shocks. The risk of rating downgrades following a sovereign downgrade is high, which could lead to a loss of confidence and financial instability.

2 – Balancing the Cost of Debt

In modern economies, government debt has become a major issue with many nations struggling to balance their debt levels and budgetary balances. Achieving fiscal sustainability demands reducing government debt, but doing so is a complex and diverse subject that calls for carefully weighing the benefits and drawbacks.

On the one hand, reducing government debt at all costs can lead to reduced government spending on infrastructure, social programs, and other socioeconomic initiatives. Thus, such an aggressive reduction can cause a potential slowdown in economic growth and higher unemployment[xxiii].

On the other hand, increasing debt further can lead to the following repercussions:

Risks to fiscal sustainability: Higher debt levels can lead to increased borrowing costs, which can pressure fiscal sustainability and pose risks to financial stability[xxiv].
Crowding out: Government borrowing can reduce private investment, ultimately slowing income growth and economic activity[xxv].
Long-term consequences: Slower income growth, reduced economic output, and higher interest rates[xxvi].

A balanced approach that considers both fiscal sustainability and the need to support growth is necessary to ensure a stable and prosperous economic future. Accordingly, this entails the following considerations:

Sustainable debt levels: Governments should aim to reduce debt levels to sustainable levels over time, taking into account the need to support economic growth and invest in essential programs[xxvii].
Growth-boosting reforms: Implementing growth-boosting reforms and, in some cases, debt relief can help reduce debt in a lasting manner, thus resulting in a stronger fiscal position, lower borrowing costs, and increased economic stability[xxviii].
Fiscal discipline and consolidation: Governments should maintain fiscal discipline, ensuring that debt is managed in a way that balances short-term needs with long-term sustainability[xxix]. This would thus provide a sustainable debt-to-GDP ratio rather than reducing debt at all costs.

3 – Required Budgetary Restrictions and Consequences

To reduce government debt, the following budgetary restrictions and measures can be implemented. However, the following policy bundles may not fully stabilize the debt-GDP ratio over time, indicating that larger reforms may still be needed[xxx]:

Expenditure cuts:[xxxi]

Cut discretionary spendings that are not strategic, and improve productivity and efficiency in the public sector
Rebuild an effective and properly targeted social security and healthcare system

Revenue increases:[xxxii]

– Establish a fair tax system

– Broaden the tax basis

– Implement a carbon tax

Fiscal rules:

– Adopt an expenditure rule that links maximum expenditure growth to potential growth, with an adjustment for committed debt reduction[xxxiii]

– Ensure compliance with the requirements of the debt reduction benchmark and base it on a well-defined and transparent methodological framework[xxxiv]

Monitoring and enforcement:

– Legally anchor the agreed debt path and implement strong commitment devices[xxxv]

– Rigorously assess compliance by considering quantifiable relevant factors[xxxvi]

Complementary policies:[xxxvii]

– Implement effective structural reforms to increase growth potential

– Maintain a price stability-oriented monetary policy

Governments need to carefully control the potential adverse effects associated with the cost of reducing their debt on key stakeholders. For example:[xxxviii]^{, [xxxix], [xl], [xli]}

Taxpayers: Given the negative impact on disposable income and consumer spending, governments will have to avoid increasing taxes on corporations and households.
Government spending: Governments will have to balance their spending to protect core sectors such as education, healthcare, and infrastructure.
Private investors: Governments have to assess the potential impact of reduced public investments in infrastructure and other projects on the private sector, and its implications on pension funds, insurance companies, and other financial institutions.
Households: The government has to weigh the effects of lower spending and higher taxes on economic growth, job opportunities, and living standards.

As such, the consequences of reducing government debt will be far-reaching and multifaceted[xlii]^{, [xliii]}. This could lead to reduced economic growth, increased unemployment, reduced public investment, increased inequality, as well as reduced social welfare programs.

In conclusion, the scope of the cost and consequences of reducing government debt is eventually dependent upon the extent, nature, and degree of balance of this reduction.

4 – Main Findings and Recommendations

On the regional level, a critical analysis of the sovereign debt and financial sector nexus in the Arab region highlights the urgent need for policy interventions to ensure fiscal sustainability and financial stability. By addressing these issues, Arab countries can create a more resilient economic environment, capable of supporting sustainable development and growth. The following findings and recommendations can be drawn:

Regional differences: MENA countries have different debt profiles and require distinct and tailored approaches to addressing their debt issues[xliv].
Policy recommendations: To address the challenges posed by the sovereign-bank nexus, the implementation of robust macroprudential and microprudential frameworks is advocated. Such policy measures should include better fiscal discipline, diversified funding sources, and enhanced regulatory oversight to monitor and manage the risks associated with sovereign debt holdings by banks. These frameworks should aim to:[xlv]
Mitigating sovereign-bank nexus: Reducing the risks associated with the close ties between sovereign debt and the financial sector.
Enhancing financial stability: Strengthening the resilience of financial institutions against sovereign risk.
Promoting economic growth: Ensuring sufficient financial resources are available for the private sector, thus fostering economic development and reducing reliance on government borrowing.
Urgent action required: Urgent action from governments, international organizations, and creditors to address the growing debt burden and prevent a debt crisis is needed. Such action should target growth-boosting policies, securing new financing, and achieving some fiscal consolidation[xlvi].

In the case of Lebanon, the local multi-faceted crisis aggravated by the late global macroeconomic tensions have plunged the Lebanese economy into a vicious circle, of which the public debt strain is a major adversity. In this context, Lebanon’s sovereign debt crisis is a major concern that requires urgent and comprehensive policy interventions. Addressing the intertwined nature of government debt and the financial sector is crucial for ensuring fiscal sustainability and financial stability.

In the midst of the crisis and political deadlock which still hinders the required structural reforms, Banque du Liban (BDL) had put an end to the fiscal dominance that was present for years. Capitalizing on its independence as a central bank, BDL stopped all funding activities to the Government of Lebanon (GoL) since August 2024, pushing the government to seek balanced budgets and to limit its expenditure to its revenues. The monetary policy since then started achieving good results especially in the stability of the exchange rate of the Lebanese Pound and building up reserves of foreign currency. The coordination with the fiscal authorities helped this achievement come true. Another major decision taken by BDL as of February 2024 was the unification of the several exchange rates that resulted as a consequence of the crisis, thus instigating a stabilizing effect on the economy. Despite all the efforts exerted by BDL to reestablish financial and monetary stability, which are needed as a transitory phase, high uncertainty in the Lebanese outlook is still linked to other critical factors that are linked to fiscal adjustment and structural reforms. Such measures are necessary to complement the monetary policy for maintaining macroeconomic stability, promoting sustainable economic recovery, and setting sovereign debt on a sustainable path. Following the elimination of multiple exchange rates achieved by the central bank, Lebanon needs to endorse a macroeconomic stabilization program to control inflationary pressures and potential currency depreciation.

As a prerequisite to any strategy, political stability is needed to undertake structural reforms and set a viable economic plan in coordination with international institutions. According to the World Bank, this plan would be based on the following: (i) a debt restructuring program that would achieve short-term fiscal space and medium-term debt sustainability; (ii) a comprehensive restructuring of the financial sector that would restore the banking sector’s solvency; (iii) the adoption of a new monetary policy framework that would rebuild confidence in the exchange rate; (iv) a phased fiscal adjustment program that would strengthen fiscal discipline to reduce budget deficits and manage debt levels effectively, thus restoring confidence in fiscal policy; (v) growth-enhancing reforms; (vi) improved social protection. Fiscal adjustment and the necessary restructuring of the banking sector will require the full realization of resulting losses under international accounting standards. These losses must then be distributed equitably according to the hierarchy of claims, taking into consideration past realized benefits[xlvii]. In addition, policy recommendations include: diversifying funding sources by reducing reliance on domestic banks for government financing and exploring alternative funding sources; enhancing regulatory oversight by developing robust macroprudential and microprudential frameworks to monitor and mitigate the risks associated with the sovereign-bank nexus[xlviii].

To face the ongoing financial crisis, BDL proposed a comprehensive transitional roadmap to the government. This roadmap endorses the following financial adjustment measures and structural reforms: (1) commitment to issue feasible annual budgets within the constitutional deadlines; (2) the Capital Control Law; (3) the Lebanese Banks Restructuring Law; (4) the Gap Resolution Law. Such reforms address correcting financial and fiscal imbalances, bringing down the current account deficit, putting the public debt on a firm downward path, restoring the stability of the financial sector, and rebuilding confidence. Confidence, in particular, is rebuilt through strengthening governance, fighting corruption, returning stolen assets, rebuilding a sustainable and growing economy, developing productive economic sectors, and providing reliable social safety nets.

Figure 9

References

[1] Gross costs represent an estimate of the total amount required to ensure the basic needs of refugees and are different from the actual amount. Capital investment, broader economic costs, and direct and indirect tax revenues are not accounted for due to lack of data.

[i] https://unctad.org/news/global-public-debt-hits-record-97-trillion-2023-un-urges-action

[ii] Ibid.

[iii] Awdeh, A., 2023. The Sovereign Debt and Financial Sector Nexus in the Arab Region. ESCWA, September 2023.

[iv] Ibid.

[v] International Monetary Fund (2022). The Sovereign-Bank Nexus in Emerging Markets. In Global Financial Stability Report, April 2022, USA: International Monetary Fund.

[vi] Awdeh, A., 2023. The Sovereign Debt and Financial Sector Nexus in the Arab Region. ESCWA, September 2023.

[vii] https://www.sciencedirect.com/science/article/pii/S1059056023003854

[viii] https://www.imf.org/en/Publications/fandd/issues/2023/09/debt-clouds-over-the-middle-east-adnan-mazarei

[ix] https://www.ispionline.it/en/event/facing-the-pandemics-burden-public-debt-and-economic-recovery-in-the-mena-region

[x] https://www.imf.org/en/Publications/fandd/issues/2023/09/debt-clouds-over-the-middle-east-adnan-mazarei

[xi] Ibid.

[xii] Ibid.

[xiii] https://reporting.unhcr.org/lebanon-factsheet-5735

[xiv] The World Bank, 2024. The Economic and Social Impact of the Syrian Conflict on Lebanon – A 10 Year Update. World bank Group, May 2024.

[xv] https://data.worldbank.org/

[xvi] https://data.unhcr.org/en/situations/syria

[xvii] Caner, M. et al, 2010. Finding the Tipping Point – When Sovereign Debt Becomes Bad. The World Bank, July 2010.