The level of debt is deemed unsafe by the International Monetary Fund (IMF) when there’s a substantial risk that, under current and anticipated policies, the debt-to-GDP ratio will persistently rise, potentially leading to default in the future[1]. Yet, determining this threshold is complex. The trajectory of the debt ratio hinges on three key factors: primary budget balances (net spending after interest payments minus revenues), the real interest rate (nominal rate minus inflation rate), and the real rate of economic growth[2].
Reserve Currency[3] vs. Non-Reserve Currency Status Countries
Debt sustainability is not a uniform concept; it varies significantly between countries with reserve currency status[4] and those without. The disparities stem from borrowing conditions, market perceptions, and the economic dynamics inherent to each status. The following elucidates why debt sustainability diverges between these two groups:
Borrowing Costs and Market Perception
Reserve Currency Status Countries: Lower borrowing costs due to their currency’s reputation as a secure and stable asset, these countries inspire investor confidence that translates into lower interest rates on their government debt. This diminished cost of borrowing facilitates the management of debt obligations.
Non-Reserve Currency Status Countries: Generally, higher borrowing costs that reflects risk perceptions tied to their currencies, leading to higher interest payments on their debt and exacerbating the challenge of debt servicing.
Foreign Exchange Risk
Reserve Currency Status Countries: Can borrow in their own currency, effectively sidestepping foreign exchange risk. Borrowing in their domestic currency obviates concerns about currency fluctuations impacting the cost of servicing foreign currency-denominated debt.
Non-Reserve Currency Status Countries: Borrowing in foreign currencies exposes countries to foreign exchange risk. Currency depreciation against the currency of borrowing can increase the cost of debt servicing.
Flexibility in Monetary Policy
Reserve Currency Status Countries: Have greater flexibility in their monetary policies since they control the issuance of their own reserve currency. They can adjust interest rates and implement measures to address economic challenges without concern for exchange rate stability.
Non-Reserve Currency Status Countries: Lacking their own reserve currency, these nations may prioritize exchange rate stability to prevent drastic currency depreciation. This prioritization can limit their leeway in shaping monetary policy.
Demand for Currency
Reserve Currency Status Countries: Countries with reserve currency status experience strong global demand for their currency, making it easier to attract foreign investment and finance their debt.
Non-Reserve Currency Status Countries: These countries might need to offer higher interest rates to attract foreign investors, especially if their currency is less widely accepted or considered riskier.
Economic Resilience
Reserve Currency Status Countries: The status can offer a certain level of economic resilience, as these countries have access to a global market for their currency. This can provide a buffer against economic shocks.
Non-Reserve Currency Status Countries: These countries may be more susceptible to economic shocks, particularly if they rely heavily on borrowing in foreign currencies or face difficulties in attracting foreign investment.
Importance of Prudent Fiscal Governance
It’s crucial to acknowledge that while reserve currency status yield benefits, it doesn’t exempt those countries from the principles of prudent fiscal management. Despite advantages, excessive borrowing can still provoke apprehensions about the trajectory debt sustainability, investor faith, and economic steadiness. Utilizing a reserve currency for borrowing doesn’t absolve the necessity for sound fiscal policies, balanced budgets, and strategic debt oversight.
Consequently, countries enjoying this privilege must proactively safeguard their economic competitiveness, stability, and responsible borrowing practices to guarantee long-term debt sustainability.
In summary, debt sustainability can differ between reserve currency status countries and non-reserve currency status countries due to factors such as borrowing costs, foreign exchange risk, monetary policy flexibility, demand for currency, and economic resilience. Reserve currency status can provide advantages that contribute to more favourable debt dynamics, but it’s essential for all countries to maintain prudent fiscal management practices to ensure the long-term sustainability of their debt.
Should you wish to discuss further, please do not hesitate to contact: Laurie Antioch, Chief Finance & Strategy Officer.
[1] IMF paper March 2022: “Deciding When Debt Becomes Unsafe (imf.org)”
[2] Not to mention evolving trade and geopolitical landscapes.
[3] A reserve currency is a foreign currency that is held in significant quantities by central banks or other monetary authorities as part of their foreign exchange reserves. For detail visit: https://en.wikipedia.org/wiki/Reserve_currency.
[4] Since 1944, the U.S. dollar has been the primary reserve currency used by other countries². However, there are other currencies that are also considered reserve currencies, including the Euro, Japanese Yen, Swiss Franc, and British Pound Sterling.