By Era Dabla-Norris, Rodrigo Valdés
High and rising debt is intensifying the interaction between fiscal policy and interest rates. New IMF research shows that when debt is already high, rising policy rates lead to a larger deterioration in fiscal deficits and debt. High debt also makes market interest rates more sensitive to fiscal developments. In the United States, for example, evidence shows that long-term forward rates have become more sensitive to projected government debt in recent years.
Long-term sovereign yields have increased sharply across several major advanced economies. Between February and September, the Group of Seven’s average 10-year government bond yield increased by over 1 percentage point, reaching its highest level in nearly two decades. Governments are confronting these higher borrowing costs at a time when debt is already elevated, with global public debt expected to exceed 100 percent of global gross domestic product by 2030, a level last reached in the immediate aftermath of World War II.
Several forces are pushing yields higher in advanced countries, including: the oil price shock, persistent inflation, stronger investment demand, and higher expected future growth linked to AI. But fiscal fundamentals are central. In major advanced economies, high debt, spending pressures, and the prospect of large bond issuance in the years ahead are putting upward pressure on the yields investors demand to hold longer-term bonds. Higher benchmark yields in major economies can also spill across borders, worsening debt dynamics elsewhere.
Rising interest costs, narrowing policy options
The pressure on budgets is already visible. The effective average interest cost of government financing is projected to rise from 2.3 percent in 2021 to 3.7 percent by 2031. Together with rising debt, this is lifting interest payments around the world.
In the United States, for example, interest payments are projected to climb from about 2.8 percent of GDP before the pandemic to 5.7 percent in 2031, roughly equal to projected expenditure on Social Security, the largest single entitlement program. In low-income countries, interest payments today consume over 15 percent of tax revenues. Between 2011 and 2019, the average cost was around 9 percent of GDP.
Rising interest bills are becoming a larger and increasingly inflexible burden on public resources, leaving less room for public investment and social spending. They also constrain governments’ ability to respond to downturns, just as demands for increased spending in defense, energy security, and aging populations are mounting.
Higher interest rates also change the debt arithmetic. In an increasing number of economies, interest rates paid for new debt now exceed expected nominal growth rates. Governments therefore need stronger primary balances to keep debt ratios from rising. Yet the global primary deficit (a government’s revenues minus expenses before interest payments) is expected to widen in 2026, moving in the opposite direction from what is needed to stabilize debt.
| The global primary deficit is about 3.3 percent of GDP in 2026. Stabilizing the global debt-to-GDP ratio this year would require cutting it down to around 2.6 percent. And because global debt is projected to keep rising, a further adjustment of a similar magnitude would be needed in the years ahead. Shorter maturities amplify the monetary-fiscal feedback Governments in several advanced economies are refinancing more debt at shorter maturities, causing higher policy rates to pass through to government borrowing costs more quickly. This matters especially when inflation remains above target and higher energy prices are adding to price pressures. Central banks may need to keep rates higher for longer, worsening debt dynamics, while fiscal concerns can themselves push market rates higher. High debt and shorter maturities can therefore make restoring price stability more difficult and more costly for the public finances. Fiscal policy must avoid adding to these pressures. Favorable window for emerging markets may not last Financing conditions for many emerging market economies have remained favorable, with strong sovereign issuance, higher commodity prices, and compressed spreads. Some frontier economies have even regained access to international markets. But this window may not last. It is unusual to see increasing yields in advanced economies alongside persistently compressed sovereign spreads in emerging markets. A shift in risk appetite could sharply reduce issuance space and widen spreads. Fiscal action is urgent Higher yields leave countries with less margin for delay. Major advanced economies with high debt need concrete measures anchored in credible medium-term plans and realistic assumptions. This is essential to put debt on a sustainable path, contain borrowing costs, and limit spillovers to the rest of the world. Emerging market economies should reduce fiscal vulnerabilities and strengthen debt management. For low-income countries where external financing is already tighter, strengthening tax systems and improving spending efficiency are essential to preserve priority spending. Delaying adjustment would cause interest burdens and fiscal vulnerabilities to build, further narrow policy options, and ultimately require a larger adjustment to stabilize debt. The more countries wait, the more painful the adjustment becomes. |
