US and China’s mounting debts could hurt us all

Joe Biden has presided over an accelerating deterioration of the US government’s finances that began with Donald Trump’s massive tax cuts for companies and the wealthy, and then exploded during the pandemic.

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The US deficit was 5.8 per cent of GDP in 2019, the year before COVID-19 spread, but had been reduced to 4.1 per cent by 2022 as the government’s pandemic spending fell away and the US economy powered along.

Then, as the Biden administration’s infrastructure spending and the green-tinged industry policies of the Inflation Reduction Act (and expensive packages of assistance to Ukraine) cut in, it began to surge again.

In an election year, the current administration isn’t going to (and hasn’t) cut spending, and Biden’s electoral policies are studded with more big-spending social policies. The fiscal centrepiece of Trump’s platform is another massive tax cut for the wealthy with an estimated cost of $US5 trillion over a decade.

The deterioration in America’s government finances has been occurring despite strong economic growth that has helped prop up the global economy even as China’s growth rate has weakened.

That’s partly due to the high interest rates on US government debt, which have soared from around 1 per cent during the pandemic to close to 5 per cent today.

It’s also partly a supply-demand issue – the sheer volume of debt being issued by the US Treasury is impacting a market with a diminished pool of buyers as the Federal Reserve Board has shifted from buying bonds to shrinking its balance sheet –, but is more influenced by the stubbornly high inflation rate.

The Fed’s chair Jerome Powell conceded this week that the expected rate cuts this year (at the start of the year there was a general expectation of six 25 basis point cuts) will be delayed and rates will remain higher for longer because the progress on lowering inflation has stalled.

The explanation for the unexpected course the US inflation rate has taken – it edged up in March – may lie in the collision between tight monetary policy and ultra-loose fiscal policies but, in any event, the prospect of the near-term relief the US budget might have gained from falling interest rates and the cost of its debt is receding.

As the IMF said, loose US fiscal policy makes the “last mile” of disinflation harder to achieve while exacerbating the debt burden.

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While China’s economic slowdown and the swelling of its debt and deficits is a concern, particularly for the emerging economies that leverage off China, the destabilisation of America’s public finances is of greater global concern.

The IMF has estimated that each percentage point increase in US Treasury bond yields flows through to as much as a 90 basis point rise in other advanced economies, with persistent consequences. For emerging markets, there is almost a complete flow-through.

The management of America’s public finances, therefore, has the potential to tighten financial conditions around the globe.

China has its own challenges as its growth rate tapers off, its population and workforce shrinks, the implosion of its property sector continues and an economic strategy that has doubled up on exports faces substantial and growing excess capacity as the strategy runs into counter-strategies and protectionist policies in its major export markets.

It has been experiencing deflation for five of its six most recent quarters. Nominal GDP was running at 4.2 per cent in the March quarter, well below real GDP of 5.3 per cent.

Weak domestic consumption from consumers scarred by China’s property market collapse and the excess capacity in its factories — the result of a flawed government attempt to generate growth through greatly expanded investment in manufacturing — risks locking China into a continuing deflationary spiral and weaker growth.

The property industry woes have a lot to do with not just the drag on growth they have generated, but the pressure they have put on local government finances, where revenue from property sales and funding for developments had been a major source of their revenues.

The instability of local governments’ finances has forced the central government to bail out some provinces and take on more responsibility – and debt – to fund its programs directly.

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China’s slowdown and a continuing build-up in its deficits and debts isn’t good for the global economy where, until quite recently, it has been the major contributor to global growth. It is particularly threatening to emerging market economies.

The IMF has estimated that a decline of one percentage point in China’s GDP growth results in an average fall in an emerging economy’s revenues of about a 0.5 percentage point of their GDP. The impact on advanced economies is less than a 0.2 percentage point of GDP.

China has also been a source of investment and funding for many emerging market economies, so any financial stress, or an effort to reduce its debt and deficits as its economic growth rates slide and its population shrinks, would also have adverse effects for those economies.

The US fiscal position is unsustainable and would’ve already been under far more significant pressure if it weren’t for the global dominance of the US dollar and the US government debt market.

China’s settings, while nowhere near as acute, are tracking towards trouble, but at least it doesn’t have the intensely partisan political impasses to deal with that bedevil the US.

How those long-term fiscal challenges are resolved matters, not just for the US and China, but for the rest of the world, most of which has been moving towards more conservative fiscal settings after the blow-outs caused by the pandemic.

There are enough trade and conflict-related threats to global stability without the growing question marks over the stability of the world’s two largest economic and military giants.